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Peru: Staff Report for the 2002 Article IV Consultation, First Review Under the Stand-By Arrangement, and Request for Modification and Waiver of Performance Criteria

Author(s):
International Monetary Fund
Published Date:
March 2003
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I. Background

A. A Brief Perspective

1. After several years of rapid growth, Peru’s economy weakened in 1998-2001, with real GDP growth averaging only 1 percent a year. The weakening resulted from adverse external shocks, little progress in structural reforms, and domestic political events. In comparison, during 1993-97, real GDP growth averaged 7 percent a year and employment growth averaged almost 6 percent a year, supported by the implementation of important structural reforms, and buoyant private investment. Inflation declined progressively since the early 1990s and was slightly negative by end-2001. Soon after taking office in July 2001, President Toledo’s government introduced a fiscal stimulus package while, at the same time, formulating a program to strengthen the medium-term fiscal outlook.

2. The Peruvian economy has so far weathered developments in the region relatively well. This can be attributed to several factors:

  • Improving fundamentals—fiscal and external current account deficits are moderate, inflation is low, and official reserves are high (covering more than 100 percent of dollar bank deposits and 190 percent of short-term external debt).
  • The financial situation of banks has also improved significantly over the last few years, and their short-term foreign liabilities are relatively small.
  • Peru’s limited trade links to countries in the region allow it to resist contagion from the current account.
  • Public sector financing is not dependent on international capital markets and could be largely covered by official creditors.
  • Private firms’ foreign borrowing is mainly carried out by subsidiaries of multinational corporations.

3. Nonetheless, the Peruvian economy has important vulnerabilities:

  • The banking system is highly dollarized, with around 80 percent of loans and 70 percent of deposits denominated in U.S. dollars. Although banks themselves have a long foreign-exchange position, they are exposed to significant credit risk as only 40-50 percent of bank clients have dollar earnings (see Section B below).
  • Public debt is relatively high at 48 percent of GDP, with about 85 percent of it denominated in foreign currency.
  • A major decentralization of government is underway. While the intention is to implement it in a phased and fiscally neutral way, the experience in other countries has been that decentralization poses risks to the public finances.

These vulnerabilities are compounded by the difficult domestic political situation. The president’s approval ratings have declined to low levels since taking office in July 2001, and there is significant opposition (including in congress) to the government’s economic policies. Such opposition could increase after the recent regional elections (held on November 17, 2002, with the new regional governments to take office January 1, 2003),2 possibly complicating the decentralization process as well as the planned elimination of regional and sectoral tax exemptions, the key plank of the government’s tax reform.

B. Developments in 2002

4. Economic activity has picked up in 2002, but private investment has not recovered and the economy remains vulnerable to further external shocks. Real GDP is projected to grow by 3.7 percent in 2002, with the 12-month rate of inflation remaining low at 2 percent (Table 1 and Figure 1). Growth has been led by exports, mainly related to the full-year operation of a large mining project; consumption has also risen following the fiscal stimulus package implemented last year. With the pickup in economic activity, labor market indicators have improved (Figure 2). On the other hand, private investment has fallen for eight consecutive quarters (although most recent data suggest that this might be bottoming out), reflecting investor concerns about the impact on Peru of the deteriorating external environment and a difficult domestic political situation.

Table 1.Peru: Selected Economic Indicators
Prel.Rev

Prog.
Proj.Prog.Prog.
1999200020012002200220032003
(Annual percentage change)
Production, prices, and trade
Real GDP0.93.10.23.73.75.03.5
Real domestic demand-3.12.4-0.73.53.35.43.1
Of which : private consumption-0.43.91.32.93.65.23.1
Consumer prices
End of period3.73.7-0.12.52.02.02.5
Period average3.53.82.01.80.22.32.2
Exports (U.S. dollars)6.315.01.111.08.57.710.8
Imports (U.S. dollars)-17.98.9-2.16.33.18.06.0
Terms of trade-8.3-2.1-2.01.33.22.02.3
Real effective exchange rate (depreciation -) 1/-2.47.24.4-4.8
Money and credit
Broad money 2/4.62.34.94.24.26.15.7
Credit to the private sector 2/-2.3-3.6-2.65.40.68.22.9
(In percent of GDP, unless otherwise indicated)
Public sector
General government current revenue17.817.517.217.017.217.517.6
General government noninterest expenditure18.718.417.717.317.617.117.2
Combined public sector primary balance-0.8-0.9-0.10.1-0.20.70.4
Interest due2.22.32.22.02.12.12.4
Combined public sector overall balance-3.0-3.2-2.3-1.9-2.3-1.4-1.9
Balance of payments
Current account-2.9-2.9-2.0-2.3-2.2-2.7-1.9
Capital and financial account1.42.52.82.54.42.92.0
Change in net international reserves
(in millions of U.S. dollars, increase -)775190-448-100-1,250-120-70
Savings and investment
Gross domestic investment21.520.118.418.818.019.418.2
Public sector4.84.03.23.13.23.03.2
Private sector16.716.115.215.714.816.415.0
National savings18.617.216.416.515.816.716.3
Public sector 3/1.80.91.01.10.91.51.3
Private sector16.816.315.415.414.915.215.0
External savings2.92.92.02.32.22.71.9
Memorandum item:
Nominal GDP (S/. billions)174.7186.8189.5201.0196.9216.3208.8
Sources: Central Reserve Bank of Peru; and Fund staff estimates and projections.

End of period. Based on Information Notice System. Data for 2002 correspond to September.

Flows in foreign currency are valued at program exchange rate.

Excludes privatization receipts.

Sources: Central Reserve Bank of Peru; and Fund staff estimates and projections.

End of period. Based on Information Notice System. Data for 2002 correspond to September.

Flows in foreign currency are valued at program exchange rate.

Excludes privatization receipts.

Figure 1.Peru: Selected Economic Indicators, 1996-2002

Source: Central Reserve Bank of Peru.

Figure 2.Peru: Labor Market Indicators, 1996-2002

Sources: Ministry of Labor; and Central Reserve Bank of Peru.

II Quarterly through 2000. Three-month moving average since 2001.

Fiscal developments

5. After sizeable fiscal stimulus in the second half of last year, fiscal policy was tightened in 2002 (EBS/02/12). The combined public sector deficit (CPSD) in July-December last year was 4 percent of GDP, reflecting mainly a boost to public spending (including a generalized wage hike). In 2002, the CPSD is projected at 2.3 percent of GDP, somewhat higher than the original program target (1.9 percent of GDP, Tables 2 and 3).3 The higher-than-programmed deficit reflects mainly spending overruns by the state healthcare agency and court rulings that require (one-off) compensation to certain workers laid-off during past privatizations. Revenues are on track, however, as an increase in excise tax rates and tax administration improvements (described below) broadly offset the impact of lower trade-related revenue and a tax amnesty approved by congress in March (Appendix III). The 2002 deficit is being financed mostly from external sources (mainly official),4 while privatization receipts and domestic debt placements have been lower than programmed. The public sector debt-to-GDP ratio will rise somewhat in 2002, in part reflecting the effective depreciation of the Sol (Figures 3 and 4).

Table 2.Peru: Operations of the Combined Pubic Sector(In percent of GDP)
Prel.Prog.Rev.

Prog.
Prog.Rev.

Prog.
1999200020012002200220032003
Central government primary balance-1.0-0.6-0.7-0.3-0.30.30.2
Revenue14.815.014.314.414.514.714.8
Current14.514.714.114.114.314.414.7
Of which: tax revenue 1/12.312.011.911.911.812.412.6
Capital0.40.30.20.30.20.30.1
Noninterest expenditure15.915.514.914.714.814.514.5
Current12.512.712.612.412.612.212.3
Capital3.42.82.42.22.22.22.2
Rest of the general government primary balance0.10.10.20.20.00.30.0
Revenue5.45.65.65.65.75.75.5
Current5.45.45.55.65.65.75.5
Capital0.00.10.10.10.10.00.0
Noninterest expenditure5.35.55.55.45.65.45.5
Current4.44.54.64.54.84.54.7
Capital0.91.00.90.90.80.90.8
Public enterprise primary balance0.0-0.50.20.2-0.00.10.1
Current balance0.90.20.60.40.40.30.4
Capital balance-0.9-0.7-0.4-0.3-0.4-0.2-0.3
Nonfinanciat public sector primary balance-0.9-1.0-0.30.1-0.30.70.3
Central bank operating balance0.10.00.20.00.10.00.1
Combined public sector primary balance-0.8-0.9-0.10.1-0.20.70.4
Interest payments2.22.32.22.02.12.12.4
External2.01.91.91.71.81.72.0
Domestic0.20.30.30.30.30.40.3
Combined public sector overall balance-3.0-3.2-2.3-1.9-2.3-1.4-1.9
Financing3.03.22.31.92.31.41.9
External-0.11.20.90.72.10.31.3
Disbursements 2/1.62.42.42.23.72.13.1
(In millions of U.S. dollars)8121,2991,3191,2502,0561,2501,800
Amortizations 2/-1.7-1.2-1.4-1.5-1.7-1.8-1.9
(In millions of U.S. dollars)-873-636-768-862-925-1,091-1,074
Condonations0.10.1-0.10.00.10.00.0
Privatization0.70.80.61.20.71.20.7
(In millions of U.S. dollars)363409327700400700400
Domestic2.41.20.8-0.0-0.5-0.1-0.1
Of which: bonds0.60.80.51.10.6
(In millions of U.S. dollars)349452267667345
Amortizations-0.3-0.3-0.3-0.2-0.6-0.6
Net deposits2.31.51.1-0.5-0.8-0.60.0
Memorandum items:3/
General government current revenue17.817.517.217.017.217.517.6
General government noninterest expenditure18.718.417.717.317.617.117.2
Public sector debt-to-GDP 4/48.045.946.245.147.743.147.8
Sources: Central Reserve Bank of Peru; Ministry of Economy and Finance; and Fund staff estimates.

Net of government IES payment and tax on assets of public enterprises (0.3 and 0.1 percent of GDP in 2002 and 2003).

Excludes the Brady bond swap of US$923 million carried out in early 2002.

Net of transfers among non-financial public institutions.

About half the deterioration in the ratio by end-2003 relative to the original program is explained by lower GDP growth and effective depreciation of the Sol. The rest reflects higher deficits and lower privatization receipts.

Sources: Central Reserve Bank of Peru; Ministry of Economy and Finance; and Fund staff estimates.

Net of government IES payment and tax on assets of public enterprises (0.3 and 0.1 percent of GDP in 2002 and 2003).

Excludes the Brady bond swap of US$923 million carried out in early 2002.

Net of transfers among non-financial public institutions.

About half the deterioration in the ratio by end-2003 relative to the original program is explained by lower GDP growth and effective depreciation of the Sol. The rest reflects higher deficits and lower privatization receipts.

Table 3.Peru: Operations of the Central Government(In percent of GDP)
Prel.Prog.Rev.

Proj.
Prog.Rev.

Proj.
1999200020012002200220032003
Current primary balance2.02.01.51.71.82.22.3
Current revenue14.514.714.114.114.314.414.7
Tax revenue 1/12.312.011.911.911.812.412.6
Direct taxes3.53.33.43.13.23.23.6
Indirect taxes8.88.78.58.88.69.29.0
Other current revenue2.22.82.22.22.62.12.1
Current noninterest expenditure12.512.712.612.412.612.212.3
Labor services 2/6.76.66.66.46.76.46.4
Goods and nonlabor services3.63.83.73.63.53.53.4
Transfers and other2.22.32.22.42.42.32.5
Capital balance-3.0-2.5-2.2-1.9-2.0-1.9-2.1
Capital revenue0.40.30.20.30.20.30.1
Capital expenditure3.42.82.42.22.22.22.2
Gross capital formation3.22.52.12.11.92.12.0
Other0.20.30.30.20.30.10.1
Primary balance-1.0-0.6-0.7-0.3-0.30.30.2
Interest payments2.12.22.12.02.02.02.3
External2.01.91.91.71.81.62.0
Domestic0.10.30.20.30.30.40.3
Overall balance-3.1-2.7-2.8-2.2-2.3-1.7-2.0
Memorandum items:
Primary balance before transfers0.60.91.21.91.82.42.5
Overall balance before transfers-1.5-1.3-0.9-0.1-0.30.40.2
Sources: Central Reserve Bank of Peru; Ministry of Economy and Finance; and Fund staff estimates.

Net of government IES payment and tax on assets of public enterprises (0.3 and 0.1 percent of GDP in 2002 and 2003, respectively).

Includes wages, salaries, and employer contributions to social security.

Sources: Central Reserve Bank of Peru; Ministry of Economy and Finance; and Fund staff estimates.

Net of government IES payment and tax on assets of public enterprises (0.3 and 0.1 percent of GDP in 2002 and 2003, respectively).

Includes wages, salaries, and employer contributions to social security.

Figure 3.Peru: Composition of Public Debt, June 2002

Source: Ministry of Economy and Finance.

1/ Millions of u.s. dollars.

2/ Domestic debt includes floating debt.

3/ Includes loans expressed as a currency basket, comprised mostly of Euro, Yen. and u.s. dollars.

Figure 4.Peru: External Indicators, 1996-2002

Sources: Central Reserve Bank of Peru; J.P. Morgan; and Fund staff estimates.

1/ Trade weighted index of nominal exchange rates. deflated by seasonally adjusted relative consumer prices. An increase (decrease) indicates appreciation (depreciation).

2/ Peruvian Brady bonds Were first issued on March 31, 1997.

3/ Correlation of standardized first difference of the natural log of the exchange rate.

Box 1.Modalities of the Review

In a letter to the Managing Director dated November 26, 2002 (Attachment I), the authorities describe developments under the program and the policies they intend to follow in 2003 and request completion of the first review under the stand-by arrangement.

The authorities are seeking modifications to the program regarding: (i) the performance criterion on the fiscal deficit for end-December 2002, consistent with the revised fiscal target for 2002; (ii) the adjuster to the performance criterion on the net international reserves of the central bank for shortfalls in privatization receipts for end-December 2002, in line with the lower-than-envisaged outturn for such receipts in 2002; and (iii) the replacement of the performance criterion on the net domestic assets of the central bank by a consultation mechanism based on inflation, consistent with their adoption of an inflation-targeting framework (see also the Technical Memorandum of Understanding, Attachment II).

The authorities are also requesting a waiver for the nonobservance of the end-September performance criterion on the NDA of the central bank, as at that point the NDA ceiling was not consistent with the annual inflation target under the inflation-targeting framework.

Performance criteria and structural benchmarks for 2003 will be set at the time of the second program review, to be completed by March 15, 2003 (phasing under the arrangement is summarized in Table 5). The review will focus in particular on: (i) progress with tax reform and the fiscal responsibility law; (ii) developments in the decentralization process; (iii) the functioning of the domestic bond market; (iv) steps being taken to strengthen banking supervision; and (v) the operations and impact of the government’s support to specific sectors.

Table 4.Peru: Quantitative Performance Criteria, January-September 2002
March 31June 30Prel.

Sept. 30
(Cumulative amounts from December 31, 2001; in millions of soles)
Borrowing requirement of the combined public sector
Unadjusted limits7501,8002,850
Adjusted limits 1/7501,8002,850
Actual3481,3162,641
Margin402484209
Net consumer lending of the Banco de la Nación
Limit200340430
Actual106139142
Margin94201288
Net domestic assets of the central reserve bank (change)
Unadjusted limits-690-920-1,535
Adjusted limits 1/-1,453-1,333-1,801
Actual-1,371-1,024-1,711
Margin-82-309-90
(Cumulative change from December 31, 2001; in millions of U.S. dollars)
Net international reserves of the central reserve bank
Unadjusted targets55125315
Adjusted targets 1/271242390
Actual324273523
Margin5331133
Stock of government guarantees for housing support programs
Limit150150150
Actual000
Margin150150150
Short-term net external debt of the public sector
Limits505050
Actual000
Margin505050
External payments arrears of the public sector(on a continuous basis) 2/
Limits000
Actual000
Margin000
(Cumulative amounts from December 31, 2001; in millions of U.S. dollars)
Contracting or guaranteeing of nonconcessional external public debt with maturity of at least one year
Total
Unadjusted limits1,1001,4001,700
Adjusted limits 1/2,0232,3232,623
Actual1,4231,9732,273
Margin600350350
Of which: 1- to 5-year maturity
Limits200200200
Actual000
Margin200200200
Sources: Central Reserve Bank of Peru; Ministry of Economy and Finance; and EBS/02/12.

The targets and limits have been adjusted in accordance with the table attached to the letter of intent dated January 18, 2002 (EBS/02/12).

Excluding arrears associated with nonrescheduled debt to foreign creditors outstanding as of end-2001.

Sources: Central Reserve Bank of Peru; Ministry of Economy and Finance; and EBS/02/12.

The targets and limits have been adjusted in accordance with the table attached to the letter of intent dated January 18, 2002 (EBS/02/12).

Excluding arrears associated with nonrescheduled debt to foreign creditors outstanding as of end-2001.

Table 5.Peru: Proposed Schedule of Purchases Under the Stand-By Arrangement, 2002–04 1/
Amount of PurchaseAvailability DateConditions Include
1. SDR 115.625 millionDecember 13, 2002Completion of the first review and observance of end-September 2002 performance criteria.
2. SDR 27.875 millionMarch 16, 2003Completion of the second review and observance of end-December 2002 performance criteria.
3. SDR 27.875 millionMay 15, 2003Observance of end-March 2003 performance criteria.
4. SDR 27.875 millionAugust 31, 2003Completion of the third review and observance of end-June 2003 performance criteria.
5. SDR 27.875 millionNovember 15, 2003Observance of end-September 2003 performance criteria.
6. SDR 27.875 millionFebruary 15, 2004Observance of end-December 2003 performance criteria.

Total access under the Stand-By Arrangement is SDR 255 million (20 percent of quota on an annual basis).

Total access under the Stand-By Arrangement is SDR 255 million (20 percent of quota on an annual basis).

6. Progress has been made with fiscal reforms, although the key step of eliminating regional and sectoral tax exemptions has been delayed.

  • A number of tax reforms were implemented (with IMF/World Bank technical assistance) and are expected to yield 0.8 percent of GDP on an annual basis. These reforms include steps to broaden the income tax base, rationalize excise taxes on petroleum products, narrow the scope of future tax-stability contracts, eliminate certain VAT exemptions, and strengthen tax audit programs (see Appendix VI).
  • A draft amendment of the fiscal responsibility law (FRL) has been sent to congress (a prior action for this review) that would, inter alia, allow a more realistic adjustment period to the medium-term fiscal target following a recession (three years rather than one), require automatic adjustments in fiscal policy in years of economic growth, and extend rules of fiscal discipline to all levels of government.
  • To improve transparency, the cost of tax exemptions has been explicitly incorporated (as tax expenditure) in the 2003 budget proposal.5
  • Pension reforms implemented have (i) standardized the pension base, lowered replacement rates, and raised the minimum pension in the general public pension system; (ii) reduced preferential survivor benefits under the special public pension system (Cédula Viva); and (iii) established a minimum pension guarantee for certain beneficiaries under the private pension system. These measures are expected to reduce the net present value of government pension liabilities by around 15 percent over the medium term (or by about 5 percent of GDP).
  • On the other hand, eliminating regional tax exemptions, a key reform in the program, was delayed as explained in paragraph 29 below. Also, the most recent tax amnesty approved earlier in the year (see EBS/02/12, Supplement 1) again risks undermining tax compliance by fostering expectations of repeat amnesties in the future.

7. Public opposition to the sale of state assets has shifted the authorities’ focus to other forms of private sector participation in state enterprise operations.6 The Private Investment Promotion Program (PIPP), which had concentrated on the sale of state enterprises, has been reoriented toward the granting of operating concessions, management contracts, and joint ventures. As a result, receipts from the PIPP are projected at US$400 million in 2002, around half the amount envisaged under the program.7

8. Backed by a strong grassroots movement to decentralize decision-making, a constitutional amendment was approved in early 2002 to decentralize the structure of government.8 The amendment established three levels of government (national, regional, and municipal) and mandated an orderly decentralization of resources and expenditure responsibilities. An omnibus decentralization law, approved in July 2002, provides an organized framework for the decentralization process.9 Key principles set out in the law include: (i) promoting accountability of government officials; (ii) requiring a transparent intergovernmental transfer mechanism; (iii) ensuring a neutral fiscal impact of decentralization; (iv) subjecting regional and local government external borrowing to Ministry of Economy and Finance (MEF) approval; and (v) setting fiscal rules for regional and local governments compatible with fiscal rules of the national government.

Monetary and financial system developments

9. In January 2002, the authorities announced the implementation of an inflation-targeting framework for monetary policy. In July, the BCRP Board announced a medium-term inflation target range of plus/minus one percentage point around a midpoint of 2.5 percent.10 Comprehensive inflation reports, along the lines of those issued in July and November, will be issued three times a year to explain inflation performance, the considerations that guided monetary policy in the preceding months, and the BCRP inflation forecast. The inflation forecast, which continues to be refined,11 is based on (i) a range of indicators (including market expectation surveys); (ii) inflation forecasting models; and (iii) other relevant factors such as the exchange rate, the stance of fiscal policy, and aggregate demand conditions. The operational target of monetary policy continues to be the monthly average stock of banks’ local currency deposits at the BCRP.

10. The stance of monetary policy has been tightened somewhat since midyear. After interest rates fell to record lows in early 2002 (reflecting the mild deflation), the central bank raised its rediscount rate by 150 basis points since September in response to heightened regional uncertainties, pressures in the foreign exchange market, and indicators of a pickup in inflation. Bank credit to the private sector has been flat in 2002, except for some increase in consumer and housing lending (Table 6 and Figures 5 and 6).

Table 6.Peru: Monetary Survey
Prog.Rev.

Prog.
Prog.Rev.

Prog.
1999200020012002200220032003
I. Central Reserve Bank
(In millions of new soles at program exchange rate)
Net international reserves1/28,14928,73929,80329,69033,36830,62534,168
(In millions of U.S. dollars)8,1598,0228,3248,3879,4268,5079,491
Net domestic assets-23,518-24,201-24,858-24,450-27,771-25,041-28,082
Net credit to nonfinancial public sector-9,966-9,390-8,758-8,874-10,217-9,092-9,931
Rest of banking system-11,462-12,488-13,695-13,401-14,996-13,588-15,639
Other-2,090-2,323-2,405-2,175-2,558-2,361-2,512
Currency4,6314,5374,9455,2405,5975,5846,086
II. Banking System
(In millions of new soles at program exchange rate)
Net foreign assets25,63026,55528,50329,24931,82430,68032,598
Net domestic assets19,80121,04321,00422,44120,11224,81122,928
Net credit to nonfinancial public sector-13,291-11,297-9,351-11,542-10,400-13,097-9,781
Credit to private sector49,16649,11247,61150,30547,45855,16349,482
Other-16,074-16,772-17,256-16,322-16,946-17,255-16,773
Net credit to COFIDE-3,074-2,395-1,732-1,692-1,367-1,718-1,388
Other-13,000-14,377-15,524-14,630-15,579-15,537-15,385
Liabilities to the private sector45,43147,59849,50751,69051,93655,49155,526
(12-month percentage change) 2/
Base money17.0-4.07.94.811.05.86.6
Broad money4.62.34.94.24.26.15.7
Domestic currency11.42.513.77.710.110.112.6
Foreign currency1.72.21.12.51.24.12.1
Credit to private sector-2.3-3.6-2.65.40.68.22.9
Domestic currency-5.30.92.79.13.012.27.0
Foreign currency-1.6-4.5-3.84.60.07.21.9
Memorandum item:
Program exchange rate (S/. per US$)3.453.603.583.543.543.603.60
Sources: Central Reserve Bank of Peru; and Fund staff projections.

Excludes subscriptions to the IMF and the Latin American Reserve Fund (FLAR), Pesos Andinos, credit lines to other central banks, Corporación Andina de Fomento (CAF) bonds, and foreign assets temporarily held by the BCRP as part of swap operations.

Flows in foreign currency are valued at the program exchange rate.

Sources: Central Reserve Bank of Peru; and Fund staff projections.

Excludes subscriptions to the IMF and the Latin American Reserve Fund (FLAR), Pesos Andinos, credit lines to other central banks, Corporación Andina de Fomento (CAF) bonds, and foreign assets temporarily held by the BCRP as part of swap operations.

Flows in foreign currency are valued at the program exchange rate.

Figure 5.Peru: Monetary Indicators, 1996-2002

Sources: Central Reserve Bank of Peru; and fund staff estimates.

1/ U.S. dollar stocks are valued at program exchange rates.

Figure 6.Peru: Interest Rates, 1996-2002

Source: Central Reserve Bank of Peru.

11. Financial dollarization remains pervasive and is a source of vulnerability(Box 2). Dollarization in Peru has been high since the late 1970s (except for a brief period in the late 1980s), with some 70 80 percent of the financial system now denominated in dollars. However, considerable risks arise because the real economy is much less dollarized (only about 40-50 percent of bank clients’ earnings are estimated to be in dollars). As a result, even though banks carry long positions in foreign currency, they are indirectly exposed to credit risk in case of a sharp depreciation of the currency. There were some signs of de-dollarization between the second half of 2001 and mid-2002 (with low inflation and a stable exchange rate), but this has since been reversed reflecting political uncertainty and regional concerns.

Box 2.Dollarization

The hanking system is highly dollarized, very liquid, and with indirect exposure to exchange rate risk in its credit portfolio. Liquidity risk is limited given batiks’ high reserves in foreign currency, relatively low and declining short-term external liabilities, small maturity mismatches, and potential access to U.S. dollar credit facilities from the BCRP (supported by the BCRP’s sizable net international reserves). Direct risk of an exchange rate depreciation is mitigated by the banks ‘ long net position in foreign currency. The average non-performing loan ratio in U.S. dollars has declined from 10.3 percent at end-2000 to 8.6 percent at end-September 2002, and is slightly higher than that in local currency. However, some estimates suggest that 50-60 percent of credit to the private sector in foreign currency is to clients that could be affected by a large depreciation (given the currency composition of their balance sheets and income and expenditure streams). Banks consider that in case of a sharp devaluation the sizable long position in foreign currency would generate resources to help provision against any rise in nonperforming loans.

There is comprehensive prudential regulation of banks’ operations in foreign currency, and the Superintendency of Banks (SBS) is considering additional norms to strengthen the management of associated risks. Current norms include: (i) capital requirements on market risk (3.2 percent), including foreign exchange risk; (ii) a minimum foreign-exchange liquidity requirement (20 percent) coupled with an average effective reserve requirement by the BCRP of just over 30 percent; and (iii) limits on the net foreign-exchange position relative to capital (2.5 percent for short positions and 100 percent for long positions). The SBS is considering the possibility of: (i) reinforcing the use of internal models of exchange-rate risk used by banks, including the hanks’ stress-test assumptions; and (ii) requiring that a debtor’s exposure and capacity to generate foreign currency be included in credit documentation.

While forward exchange market operations have increased substantially in 2002, this hedging instrument continues to be a limited alternative for most debtors. The market continues to be small and one-sided, as most exporters do not sell foreign exchange forward; thus, banks make up almost all of the supply side of the market. To cover these open forward positions, banks purchase foreign exchange in the spot market; hence, stepped up demand for forward dollars introduces volatility in the spot exchange rate.

Peru; Dollarization in Commercial Banks(In percent, unless otherwise indicated)
1998199920002001Q3 2002
FX- denominated loans to total loans80.282.682.680.680.8
FX- denominated deposits to total deposits77.378.578.776.176.3
Liquid FX assets to short-term FX Liabilities30.635.138.045.249.5
FX-denominated NPLs to total FX-denominated loans7.28.710.39.98.6
Net FX position to capital49.238.137.037.641.5
Short-term foreign liabilities (millions of U.S. dollars)2,8791,8351,5191,1881,224
Source: BCRP and SBS.
Source: BCRP and SBS.

12. Other banking system indicators have generally improved in 2002, and the SBS has taken several steps recently to strengthen bank supervision(in line with FSAP 2000 recommendations, see Appendix IX). As noted, average nonperforming loan ratios have declined; loan provisioning is up; and the profitability of most banks has risen (Figure 7). A large foreign-owned bank recently experienced deposit outflows related to the owner’s publicly stated intention to withdraw from the region. The owner has since announced a substantial capital injection, scheduled to occur in early December. In 2002, the SBS introduced regulations on country and operational risk, and prudential requirements were applied on a consolidated basis. Draft legislation has been submitted to congress to grant legal protection to bank supervisors (a prior action for this review). In 2002 an anti-money laundering unit in the MEF was established, and its operational norms are being formulated.

Figure 7.Peru: Banking Indicators, 1996-2002

Source: Superintendency of Banks and Insurance.

1/ Adjusted for the bond-for-loan swap programs from August 1999.

13. Special lending programs have been implemented in a prudent manner, and steps have been taken to strengthen corporate governance and restructuring procedures. The consumer lending program of Banco de la Nación has been kept below the ceilings in the program, with repayment conditions fully respected. The agrarian bank has limited its first-tier lending operations to small-scale agricultural producers (from resources in the budget); it will lend to larger producers by channeling foreign credit lines through financial institutions supervised by the Superintendency of Banks (SBS). A new bankruptcy procedure law was approved in August, which limits court intervention and better balances the rights of creditors and debtors. In addition, regulations were issued to strengthen corporate governance and increase the transparency of domestic securities markets.

External developments

14. The external position has strengthened in 2002, both in the current and capital accounts(Table 7 and Figure 8). Exports are projected to grow by around 8.5 percent (in U.S. dollar terms), while imports are growing more slowly given weak private investment growth. Net capital inflows have been strong (Table 8), mainly reflecting Peru’s recent return to the private international capital market (Box 3). As a result, official reserves are expected to increase by some US$1.25 billion, to around US$10 billion, more than covering the stock of bank dollar deposits and equivalent to 190 percent of short-term external debt.

Table 7.Peru: Balance of Payments
Prel.Prog.Rev.

Prog.
Prog.Rev.

Prog.
1999200020012002200220032003
(In millions of U.S. dollars)
Current account-1,478-1,568-1,094-1,334-1,239-1,643-1,120
Merchandise trade-630-317-90151289142674
Exports6,1207,0347,1087,9157,7138,5258,545
Traditional4,1434,8214,7435,4115,2695,8095,746
Nontraditional1,9772,2132,3332,5052,4442,7162,798
Imports-6,750-7,351-7,198-7,764-7,424-8,383-7,871
Services, income, and current transfers (net)-847-1,252-1,004-1,486-1,528-1,787-1,793
Service a-666-793-800-789-860-892-915
Investment income-1,146-1,452-1,203-1,682-1,572-1,949-1,832
Current transfers9649939999859041,057954
Financial and capital account6731,4371,5111,4122,4341,7391,165
Public sector3832803933231,081134709
Disbursements1,2371,4851,3441,3002,9411,3001,878
Amortization-971-1,042-918-941-1,889-1,131-1,113
Other medium- and long-term public sector flows 1/117-163-33-3629-35-56
Capital transfers (net)-54-69-680000
Privatization219229267665245665340
Private sector1269979194231,110940116
Foreign direct investment (FDI) excluding privatization1,5934337965371,6771,066219
Other private capital-1,467564123-114-567-126-103
Medium- and long-term Loans350603358240-3398880
Portfolio investment-297-300-271-189-321-179-184
Short-term flows to the financial system 2/-1,424-86-325-2450-400
Other short term flows (including errors and omissions)-96347360809351
Financing805131-417-78-1,195-96-45
Change in central bank reserves (increase -)775190-448-100-1,250-120-70
Exceptional financing30-583123552426
Debt relief 3/3803323552426
Change in arrears-8-58-20000
(In percent of GDP unless otherwise specified)
Memorandum items:
Current account (CA) balance-2.9-2.9-2.0-2.3-2.2-2.7-1.9
FDI and private MLT capital (percent of CA deficit)131.566.1105.558.2108.070.226.7
Capital and financial account balance1.32.72.82.54.42.92,0
Export value (US$), percent change6.315.01.111.08.57.710.8
Volume growth14.811.56.39.96.53.78.0
Price growth-7.43.1-4.91.01.93.92.6
Import value (US$), percent change-17.98.9-2.16.33.18.06.0
Volume growth-18.53.41.06.62.S6.05.0
Price growth0.75.3-3.1-0.30.31.81.0
GDP (millions of US$)51,62853,51354,02356,81755,94360,07257,686
Sources: Central Reserve Bank of Peru; Ministry of Economy and Finance; and Fund staff estimates and projections.

Includes medium- and long-term flows of the financial public sector and subscription payments into international funds.

Includes COFIDE and Banco de la Nación.

Debt relief for 2002-2003 from Paris Club creditors.

Sources: Central Reserve Bank of Peru; Ministry of Economy and Finance; and Fund staff estimates and projections.

Includes medium- and long-term flows of the financial public sector and subscription payments into international funds.

Includes COFIDE and Banco de la Nación.

Debt relief for 2002-2003 from Paris Club creditors.

Figure 8.Peru: Trade Indicators, 1996-2002

Source: Central Reserve Bank of Peru.

Table 8.Peru: External Financing Requirements and Sources(In millions of U.S. dollars)
Prel.Prog.Rev.

Prog.
Prog.Rev,

Prog.
1999200020012002200220032003
1. Gross financing requirements8,6398,1446,9957,2088,3857,7336,421
External current account deficit (excluding official transfers)1,4781,5681,0941,3341,2391,6431,120
Debt amortization7,9336,7425,4665,7745,8965,9705,231
Medium- and long-term debt2,0392,4871,7972,1842,7942,4951,933
Public sector9711,0429189411,8891,1311,113
Multilateral 1/273531334410397470479
Bilateral365389490472544588578
Bonds and notes31910883509406750
Other1512109866
Private sector1,0681,4458791,2439051,364820
Short-term debt 2/5,8944,2553,6693,5903,1023,4753,298
Repayment of arrears 3/85820000
Accumulation of NIR-780-2244331001,25012070
Change in gross reserves-954-362289-551,105411
Payments of short-term liabilities of the central bank1741381441551457969
IMF repurchases and repayments1791721601551387969
Other-5-34-160700
2. Available financing8,5057,6326,5237,1858,0127,7096,395
Foreign direct investment (net)1,8126621,0631,2021,9221,731559
Privatization219229267665245665340
FDI1,5934337965371,6771,066219
Portfolio (net)-297-300-271-189-321-179-184
Short-term assets (flow)-3723181-50-423-1350
Debt financing from private creditors5,6975,7524,3394,9585,7555,0274,898
Medium- and long-term financing1,4422,0831,2371,4832,4571,4521,600
To public sector2535001,8910700
Of which: balance of payments financing 3/0000000
To private sector1,4182,0481,2371,4835661,452900
Short-term financing4,2553,6693,1023,4753,29S3,5753,298
Of which: balance of payments financing 3/0000000
Official creditors 4/1,2131,4501,3441,3001,0501,3001,178
Multilateral 1/9607941,1041,0718221,040895
Of which: balance of payments financing414471876850617819650
Bilateral253656239229228260283
To public sector253656238229228260283
Of which: balance of payments financing030000000
To private sector0000000
Other medium- and long-term public sector flows 5/117-163-33-3629-35-56
IMF0000000
Accumulation of arrears (exceptional)0000000
3. Financing gap134512472233732426
Other flows 6/134512472233732426
Errors and omissions96512441031800
Debt relief3803123552426
Sources: Central Reserve Bank of Peru; and Fund staff estimates and projections.

Excluding IMF.

Original maturity of less than one year. Equals stock at the end of the previous period. Excludes BCRP short-term debt.

Most of the external arrears are owed to unguaranteed suppliers, some of which are in discussions with the government, while the rest have not been located.

Includes both loans and grants.

Includes subscription payments to international organizations and changes in Banco de la Nation’s long-term assets.

Includes all other net financial flows (including exceptional financing) and errors and omissions.

Sources: Central Reserve Bank of Peru; and Fund staff estimates and projections.

Excluding IMF.

Original maturity of less than one year. Equals stock at the end of the previous period. Excludes BCRP short-term debt.

Most of the external arrears are owed to unguaranteed suppliers, some of which are in discussions with the government, while the rest have not been located.

Includes both loans and grants.

Includes subscription payments to international organizations and changes in Banco de la Nation’s long-term assets.

Includes all other net financial flows (including exceptional financing) and errors and omissions.

15. The exchange rate has continued to float, with intervention limited to smoothing short-term volatility. After being relatively stable since mid-2001, the exchange rate came under pressure in August-September 2002 amid growing regional uncertainties. The central bank responded by tightening monetary policy and intervening modestly in the foreign-exchange market. The exchange rate has since stabilized.12 In real effective terms, the Sol has depreciated by 5 percent so far this year, partially reversing the appreciating trend over the last few years (following the U.S. dollar, to which most Peruvian exports and financial transactions are linked). The current level of the exchange rate does not seem to be a problem for the competitiveness of Peruvian exports; rather, exports would benefit most from improvements in road and port infrastructure, which would lower transportation costs and allow for expanded export volumes.

Box 3.Peru’s Brady Bond Swap and Global Bond Issue

In February 2002, Peru accessed international capital markets through a sovereign bond issue (the first such placement since 1928). The transaction involved the issuing of fixed-coupon, 10-year, global bonds for US$1,423 million, of which US$923 million were exchanged for existing Brady bonds with a face value of US$1,204 million.

The strategic goal of the operation was to broaden the government’s sources of financing, while extending the maturity profile of the public debt. In recent years, the Peruvian government has relied on credits from official external sources—mainly multilaterals—and privatization receipts to finance its fiscal deficits. Neither of these are sustainable sources of financing, as most state enterprises have been sold and Peru should graduate soon from official development programs. At the same time, grace periods on some of the Brady bonds and other loans are beginning to expire, increasing the governments’ amortization payments in the near term.

In addition, the global bond provides a useful benchmark instrument for Peruvian firms. For international corporate bond issuers, sovereign bonds typically serve as a reference price. Until the global issue, Brady bonds had been the only traded sovereign Peruvian debt, but because of their complexity they are difficult to price and, thus, are poor benchmarks.

The exchange reduced the stock of public debt and, by taking advantage of pricing inefficiencies associated with Bradys, generated a small net-present-value saving. The swap reduced the nominal debt stock by US$280 million and freed US$50 million of collateral.

The exchange also provided some hedge against future interest rate hikes and increased slightly the duration of Peru’s debt. Since three of Peru’s Brady bonds carry floating rates (or will soon switch from fixed to floating rates), their exchange for a fixed coupon instrument helped to reduce the interest rate risk of the public-debt portfolio. Low international interest rates at the time of the swap provided the additional advantage of allowing Peru to lock-in these favorable rates. The swap extended the modified duration from 6.1 years for the existing Bradys to 6.4 years for the new combined Brady-Global bond portfolio.

At the same time, the exchange does have some costs and risks. The duration gain comes at the cost of higher interest coupon payments on the global bond (at least in the near term), and the gradual amortization of the exchanged Bradys posed a lower rollover risk than the bullet payment on the global bond.

16. The impact of political uncertainty and regional sentiment on financial developments has been limited(Table 9). Both dollar- and Sol-denominated bank deposits have grown throughout most of the year, and official reserves have risen. Sovereign spreads on Peruvian debt were at 742 basis points (bps) at end-October, some 220 bps above their end-2001 level (compared with an average rise in spreads for countries in the region of about 420 bps).

Table 9.Peru: Financial and External Vulnerability Indicators(In percent; unless otherwise indicated)
Prel.Prog.Proj.Prog.Proj.
1999200020012002200220032003
Financial indicators
Public sector debt/GDP48.045.946.245.147.743.147.8
Of which: in domestic currency (percent of GDP)5.75.96.87.17.1
90-day prime lending rate, domestic currency 1/21.218.215.28.4
90-day prime lending rate, foreign currency 1/11.810.79.02.7
Velocity of money 2/3.93.93.83.93.93,93.8
Credit to the private sector/GDP27.926.025.024.624.125.123.7
Share of foreign currency deposits in total deposits77.377.975.974.674.173.572.0
Share of foreign currency loans in total credit82.381.581.180.380.179.879.6
Nonperforming loans/total loans 3/4/9.411.211.08,7
Loan-loss provisions/nonperforming loans 3/4/79.478.590.0115.3
Risk-based capital-assets ratio 4/12.012.913.413.3
Foreign currency deposits at commercial banks (in millions of U.S. dollars)9,1339,2609,3219,5619,6559,9609,855
Commercial banks’ short-term foreign assets (in millions of U.S. dollars)981824750861977861977
Commercial banks’ short-term foreign liabilities (in millions of U.S. dollars1,8351,5191,1881,2391,4511,2391,451
External indicators
Exports, U.S. dollars (percent change)6.315.01.111.08.57.710.8
Imparts, U.S. dollars (percent change)-17.98.9-2.16.33.18.06.0
Terms of trade (percent change)-8.3-2.1-2.01.33.22.02.3
Real effective exchange rate, (end-period, percent change) 1/-2.47.24.4-4.8
Current account balance (percent of GDP)-2.9-2.9-2.0-2.3-2.2-2.7-1.9
Capital and financial account balance (percent of GDP)1.42.52.82.54.22.92.0
Total external debt (percent of GDP)55.252.550.950.251.047.950.8
Medium- and long-term public debt (percent of GDP) 5/38.736.535.534.936.733.236.8
Medium- and long-term private debt (percent of GDP)7.89.09.79.18.48.78.2
Short-term public and private debt (percent of GDP)8.76.95.86.15.96.05.7
Total external debt (percent of exports of goods and services) 5/372.3326.2320.0302.8309.3284.6288.6
Total debt service (percent of exports of goods and services) 6/54.450.239.438.635.539.834.7
Gross official reserves (in millions of U.S. dollars)9,0038,5638,8388,8539,9428,9049,941
Gross official reserves, percent of short-term external debt 7/122.1154.3149.3156.0189.8146.3184.8
Gross official reserves, percent of broad money 8/68.064.062.160.368.057.565.2
Gross official reserves, percent of foreign currency deposits at banks98.692.594.892.6103.089.4100.9
Gross official reserves (in months of imports of goods and services)11.110.810.89.811.59.010.7
Net international reserves (in millions of U.S. dollars)8,4048,1808,6138,7139,8638,8339,933
Net international reserves (program definition; in millions of U.S. dollars) 9/5,1954,8915,0565,0945,5935,1165,461
Net international position (in millions of U.S. dollars) 10/2,5382,6242,9153,1103,110
Financial market indicators
Stock market index (U.S. dollars) 11/523.4342.8342.1342.4
Foreign currency debt rating (Moody’s) 11/Ba3Ba3Ba3Ba3
Spread of Peruvian Brady bonds, basis points 11/12/443687521742
Sources: Central Reserve Bank of Pent; and Fund staff estimates and projections.

At end of period. For 2002, interest rates correspond to October prime corporate rales, and the REER to September.

Defined as the inverse of the ratio of end-period broad money to annual GDP.

Annual average. Since 2000, includes adjustment for an estimate of nonperforming loans that were temporarily exchanged for government bonds.

Preliminary data for 2002 correspond to September.

Includes Central Reserve Bank of Peru debt.

Includes debt service to the Fund, For 2002, excludes US$923 million of Brady bonds that were amortized in a debt exchange operation.

Short-term debt includes amortization of medium- and long-term loans falling due over the following year.

At end-period exchange rate.

Includes financial system’s foreign currency deposits in central bank as reserve liability.

Includes public sector foreign currency deposits in central bank (e.g. pension reserve funds) as reserve liability.

For 2002, data correspond to end-October.

Over U.S. Treasury bond yields of comparable maturity.

Sources: Central Reserve Bank of Pent; and Fund staff estimates and projections.

At end of period. For 2002, interest rates correspond to October prime corporate rales, and the REER to September.

Defined as the inverse of the ratio of end-period broad money to annual GDP.

Annual average. Since 2000, includes adjustment for an estimate of nonperforming loans that were temporarily exchanged for government bonds.

Preliminary data for 2002 correspond to September.

Includes Central Reserve Bank of Peru debt.

Includes debt service to the Fund, For 2002, excludes US$923 million of Brady bonds that were amortized in a debt exchange operation.

Short-term debt includes amortization of medium- and long-term loans falling due over the following year.

At end-period exchange rate.

Includes financial system’s foreign currency deposits in central bank as reserve liability.

Includes public sector foreign currency deposits in central bank (e.g. pension reserve funds) as reserve liability.

For 2002, data correspond to end-October.

Over U.S. Treasury bond yields of comparable maturity.

II. Outlook

17. The 2003 program outlook is based on maintaining growth at about its 2002 rate and continued low inflation. Growth will be slower than the 5 percent originally assumed in the program, reflecting weaker private investment, and would be led by exports. Inflation is projected to be at the mid-point of the central bank’s inflation target range. Key economic objectives for 2003 are as follows:

Macroeconomic Framework 2002-03
(In percent)20022003
Real GDP growth3.73.5
Inflation2.02.5
External current account deficit (percent of GDP)2.21.9
NIR accumulation (in millions of U.S. dollars)1,25070
Gross official reserve coverage of:
Dollar deposits in the banking system103102
Short-term external debt190185

18. The external position is expected to strengthen somewhat further in 2003. The current account deficit is projected to fall below 2 percent of GDP in 2003 as exports benefit from new mining projects coming on line, firming mineral prices, and the full-year effect of expanded U.S. trade preferences for Andean countries (ATPDEA).13 Private capital inflows should pick up gradually in 2003 assuming increased political stability, and net public sector inflows would be around the same as in 2002. These projections are consistent with a modest increase in net international reserves.

19. The baseline medium-term outlook is favorable. Assuming that sound macroeconomic policies and structural reforms continue, Peru should be able to achieve real GDP growth rates of 5 percent over the medium term with low inflation (Table 10 and Box 4).14 Key policies include bringing the fiscal deficit under 1 percent of GDP, thereby lowering the public debt-to-GDP ratio to 30 percent by 2012. The external current account deficit would rise temporarily in the near term as investment picks up, but would return to below 2 percent of GDP over the medium term, with the potential for both exports and imports of goods and services to grow relatively rapidly. The baseline assumes an improving external environment that would allow net capital inflows to increase over the medium term in line with the projected rise in foreign direct investment. This scenario maintains solid levels of reserve coverage15, with debt indicators improving over the medium term16. In this context, Peru should be able to comfortably meet its obligations to the Fund (Table 11).

Table 10.Peru: Medium-Term Outlook
Projections
200120022003200420052006200720082009201020112012
I. Balance of Payments and Other External Indicators
(In billions of U.S. dollars)
Current account-1.1-1.2-1.1-1.3-1.4-1.0-0.9-1.2-1.5-1.7-1.8-2.0
Merchandise trade-0.10.30.70.91.11.71.92.01.91.92.02.1
Exports7.17.78.59.410.512.013.514.816.017.318.820.3
Imports-7.2-7.4-7.9-8.5-9.3-10.3-11.6-12.8-14.2-15.4-16.8-18.3
Services-0.8-0.9-0.9-0.9-1.0-1.0-1.1-1.1-1.2-1.2-1.3-1.3
Investment income-1.2-1.6-1.8-2.2-2.6-2.8-2.9-3.2-3.4-3.7-4.0-4.2
Current transfers1.00.91.01.01.01.11.21.21.31.41.41.5
Capital and financial account1.52.41.21.51.61.31.21.51.82.02.12.3
Public sector0.41.10.70.60.50.50.40.30.20.10.0-0.1
Disbursements 1/1.32.91.91.91.91.91.91.91.91.91.93.8
Amortization due-0.9-1.9-1.1-1.3-1.3-1.3-1.5-1.5-1.7-1.7-1.9-3.8
Other medium- and long-term public flows 2/0.00.0-0.1-0.1-0.1-0.10.00.00.00.00.00.0
Private sector1.11.40.51.01.10.80.81.21.61.82.12.4
Privatization receipts from direct investment0.30.20.30.0.10.00.00.00.00.00.00.0
Direct investment, excluding privatization0.81.70.20.90.70.40.20.51.01.21.51.8
Other 3/0.1-0.6-0.10.00.40.40.60.60.60.60.60.5
Overall balance0.41.20.00.30.30.30.30.30.30.30.30.3
Change in central bank reserves-0.4-1.3-0.1-0.3-0.3-0.3-0.3-0.3-0.3-0.3-0.3-0.3
Exceptional financing 4/0.00.10.00.00.00.00.00.00.00.00.00.0
(In percent of exports of goods and services)
Total external debt service 5/39.435.534.734.733.631.630.128.827.725.924.831.8
Public external debt service 5/23.421.922.623.222.120.419.518.718.317.416.924.5
(In months of next year’s imports of goods and services)
Gross reserves10.811.510.710.19.58.88.27.77.36.96.56.7
(In percent of short-term external debt on a residual-maturity basis)
Gross reserves149.3189.81S4.8187.8188.21873188.118871942195.3151.8155.5
(In percent of broad money)
Gross reserves62.168.065.262.960.658.355.853.350.748.045.342.6
(In percent of GDP)
Current account deficit-2.0-2.2-1.9-2.0-2.0-1.4-1.2-1.4-1.7-1.8-1.8-1.8
Merchandise exports13.213.814.815.315816.917.618.118.318.518.718.9
Merchandise imports13.313.313.613.814.114.515.215.716.216.516.716.9
Total external debt50.951.050.848.747.245.042.840.738.536.533.632.1
Total medium- and long-term public external debt 6/35.536.736.835.433.932.330.629.027.425.623.422.2
II. Output and Prices
(Annual percentage change)
Real GDP0.23.73.54.64.95.75.35.15.05.05.15.0
Real domestic demand-0.63.33.14.44.84.94.95.05.05.15.05.1
Of which:
Private consumption1.33.63.13.94.64.44.44.44.44.44.44.4
Private investment-5.61.04.57.57.07.07.07.07.57.57.57.5
Consumer prices (end of period)-0.11.52.52.52.52.52.52.52.52.52.52.5
(In percent of GDP)
III. Savings and Investment
Gross domestic investment18.418.018.218.618.819.119.419.820.320.721.221.6
Public sector3.23.03.13.13.03.13.13.23.23.33.43.4
Private sector15.215.015.115.515.816.016.316.617.117.417.818.2
National savings16.415.816.316.616.817.618.218.418.619.019.419.8
Public sector 7/1.00.91.31.72.02.12.22.32.42.62.82.8
Private sector15.414.915.014.914.815.616.016.116.216.416.617.0
External savings2.02.21.92.02.01.41.21.41.71.81.81.8
IV. Combined Public Sector
Combined public sector primary balance-0.1-0.20.40.91.41.41.41.41.51.51.51.5
Of which:
General government current revenue17.217.217.417.717.917.917.917.918.118.118.118.1
General government non-interest expenditure17.717.617.217.016.716.716.716.816.816.816.816.7
Interest due2.22.12.42.42.42.52.52.52.52.52.52.2
Combined public sector overall balance-2.3-2.3-1.9-1.4-1.0-1.0-0.9-0.9-0.8-0.7-0.6-0.6
Net external financing0.92.11.31.00.90.70.50.40.20.20.10.0
Net domestic financing 8/0.8-0.5-0.10.40.00.20.40.50.50.40.50.5
Privatization receipts0.60.70.70.10.10.10.10.00.00.00.00.0
Public sector debt 9/46.247.747.846.243.941.739.637.735.833.831.829.9
Sources: Central Reserve Bank of Peru; and Fund staff estimates and projections.

Includes bonds.

Includes medium- and long-term flows of the financial public sector and subscription payments into international funds.

Includes errors and omissions.

Includes debt relief from Paris Club creditors, and debt forgiveness.

For 2002, excludes US$923 million in Brady bonds that were amortized through a debt exchange operation.

Includes Central Reserve Bank of Peru debt.

Excludes privatization receipts.

Includes statistical discrepancy.

Domestic debt includes floating debt.

Sources: Central Reserve Bank of Peru; and Fund staff estimates and projections.

Includes bonds.

Includes medium- and long-term flows of the financial public sector and subscription payments into international funds.

Includes errors and omissions.

Includes debt relief from Paris Club creditors, and debt forgiveness.

For 2002, excludes US$923 million in Brady bonds that were amortized through a debt exchange operation.

Includes Central Reserve Bank of Peru debt.

Excludes privatization receipts.

Includes statistical discrepancy.

Domestic debt includes floating debt.

Table 11.Peru: Projected Payments to the Fund as of December 13, 2002 1/(In millions of SDRs)
Overdue2002200320042005200620072008200920102011Total
Obligations from existing

drawings
Principal (repurchases)00.080.326.826.826.813.40.00.00.00.0174.1
Charges and interest 2/
On Fund credit00.03.72.41.60.80.10.00.00.00.08.6
On use of SDRs00.02.02.02.02.02.02.02.02.02.018.0
Total obligations00.086.031.130.329.515.52.02.02.02.0200.4
(percent of quota)00.013.54.94.74.62.40.30.30.30.331.3
Obligations from

prospective drawings
Principal (repurchases)00.00.00.00.078.7124.048.83.50.00.0255.0
Charges and interest 2/
On Fund credit00.64.67.37.46.84.11.00.00.00.031.8
On use of SDRs00.00.00.00.00.00.00.00.00.00.00.0
Total obligations00.64.67.37.485.5128.149.83.50.00.0286.8
(percent of quota)00.10.71.11.213.420.07.80.50.00.044.9
Cumulative (existing

and prospective)
Principal (repurchases)00.080.326.826.8105.5137.448.83.50.00.0429.1
Charges and interest 2/
On Fund credit00.68.39.89.07.64.21.00.00.00.040.5
On use of SDRs00.02.02.02.02.02.02.02.02.02.018.0
Total obligations00.690.638.637.8115.1143.651.85.52.02.0487.6
(percent of quota)00.114.26.05.918.022.58.10.90.30.376.3
(percent of GDP)00.00.20.10.10.20.30.10.00.00.01.0
(percent of exports of goods and services)00.01.20.50.41.11.20.40.00.00.04.8
Memorandum items:
Purchases115.6111.527.90.00.00.00.00.00.00.0255.0
Fund credit outstanding
(end period)289.7320.9322.0295.2189.752.33.50.00.00.0
(percent of quota)45.350.250.446.229.78.20.50.00.00.0
(percent of GDP)0.70.70.70.60.40.10.00.00.00.0
Sources: Treasurer’s Department; and Fund staff estimates and projections.

Assuming all scheduled purchases are made. Repurchases assumed to be made under obligation schedule.

Projections are based on current rates of charge, including burden-sharing charges where applicable, for purchases in the GRA, and on current interest rates for PRGF and Trust Fund. The current SDR interest rate is assumed for net use of SDRs.

Sources: Treasurer’s Department; and Fund staff estimates and projections.

Assuming all scheduled purchases are made. Repurchases assumed to be made under obligation schedule.

Projections are based on current rates of charge, including burden-sharing charges where applicable, for purchases in the GRA, and on current interest rates for PRGF and Trust Fund. The current SDR interest rate is assumed for net use of SDRs.

Box 4.Sources of Growth: The 1990s and Beyond

Peru should be able to achieve average growth of around 5 percent a year over the medium term provided that prudent macroeconomic policies continue and needed structural reforms are implemented. Standard growth accounting methodology suggests that the assumed medium-term growth path is consistent with realistic projections for productivity and factor growth.

GDP growth in Peru during the period 1991-2001 averaged 3.7 percent. Much of the growth was driven by capital accumulation. However, performance varied significantly during the subperiods 1993–97 and 1998—2001.

  • During 1993-97, Peru benefited from favorable external conditions and an ambitious program of first-generation structural reforms, including privatization, pension reform, and trade liberalization. This environment created conditions for a high rate of investment and rising productivity, which allowed the economy to grow at an annual rate of 7.1 percent. Factor productivity explained more than 40 percent of growth during this period.
  • The period 1998-2001 was marked by adverse external shocks, little progress in structural reforms, and political events. These factors combined to deter private investment (which contracted in each year) and limited growth to an average rate of 0.9 percent. The decline of total factor productivity reduced growth by 2.8 percentage points on average during this period.

Continuation of sound macroeconomic policies and a revitalized structural reform agenda, along with increased international trade opportunities, should provide a favorable environment for private investment and factor productivity growth over the medium term. On this basis, the Peruvian economy should be able to sustain growth rates of around 5 percent over the medium term. Expanding opportunities in the export sector, both traditional and nontraditional (many of which are labor-intensive), together with structural reforms (especially the PIPP initiative), and investment in infrastructure and human capital should promote private investment, spur employment of the growing labor force, and raise factor productivity. Ongoing efforts to strengthen the institutional and legal environment should also contribute to improving the investment climate.

Peru: Contribution to Growth(In percent)
GDPCapitalLaborProductivityPrimarySecondaryTertiary
1991-20013.72.11.00.60.70.82.2
1993-19977.12.61.53.01.01.84.2
1998-20010.91.81.9-2.80.8-0.20.4
2002-20124.81.91.11.8
Sources: Jose Valderrama, el al. (2001). “Productividad y Crecimiento Economico en el Peru”; and Fund staff estimates.

The computations are based on a standard growth accounting methodology. The production function is Cobb-Douglas (with a labor coefficient of 0.36), and the estimates for the 2002-12 period are based on the medium-term projections underlying Table 10. For this period, an annual rate of 3 percent is assumed for labor growth, and the construction of the capital series assumes a 5 percent depreciation rate.

Sources: Jose Valderrama, el al. (2001). “Productividad y Crecimiento Economico en el Peru”; and Fund staff estimates.

The computations are based on a standard growth accounting methodology. The production function is Cobb-Douglas (with a labor coefficient of 0.36), and the estimates for the 2002-12 period are based on the medium-term projections underlying Table 10. For this period, an annual rate of 3 percent is assumed for labor growth, and the construction of the capital series assumes a 5 percent depreciation rate.

20. There are, nevertheless, important risks to the medium-term outlook. In particular:

  • A deepening of regional and other external difficulties would likely affect growth, as capital inflows and the assumed recovery in private investment could stall. This could put pressure on the authorities to carry out a countercyclical fiscal policy, undermining fiscal consolidation. It could also put pressure on the exchange rate, which would affect the (partly unhedged) corporate sector and, in turn, erode the quality of bank loan portfolios.
  • The high degree of financial dollarization will expose banks to credit risk in the event of a sharp depreciation of the currency.
  • Fiscal sustainability requires completion of tax reform and fiscally neutral implementation of decentralization, both of which could be at risk if the domestic political situation were to deteriorate.
  • Sensitivity analysis of the medium-term balance of payments and debt projections suggest that the outlook is quite robust to shocks to key parameters, although debt ratios would rise significantly in case of a large and sustained depreciation of the Sol (given the high share of debt denominated in foreign currency).

III. PolicyDiscussions

21. The authorities considered that their economic policy framework will maintain macroeconomic stability, reinforce an already solid financial system, and provide a basis for sustained rapid growth. The framework centers on medium-term fiscal consolidation, inflation targeting with a floating exchange rate, and supporting structural reforms. The authorities noted that Peru’s sound fundamentals, led by high official reserves, had helped shield the country from regional contagion. Looking forward, they considered that solid growth would continue in 2003 and accelerate thereafter, given the completion of major natural resource projects and the prospects for increased trade opportunities under the hemispheric free-trade area envisaged to begin in 2006.

22. The staff supported the authorities’ overall policy framework, in particular their focus on financial sector soundness and high official reserve coverage as key elements of strength of the Peruvian economy. There was broad agreement that medium-term growth prospects depended importantly on the continuation of prudent macroeconomic policies and structural reforms to create a sound investment climate. Given the economy’s vulnerabilities and the uncertain regional outlook, the staff underscored the importance of containing the risks of financial dollarization and maintaining sustainable public-debt dynamics. Staff also emphasized that policies should also aim at reversing dollarization of the banking system, and that this should be a key objective for the medium term.

A. Fiscal Policies

23. The authorities firmly plan that the fiscal deficit decline next year, to give credibility to their medium-term fiscal deficit target. They considered that the moderate consolidation should not jeopardize economic recovery. Thus, the overall public sector deficit in 2003 is targeted to decline by about ½ percent of GDP, to 1.9 percent of GDP, with a similar adjustment in the primary balance (Table 2). The adjustment reflects mainly an increase in tax revenue, on the strength of the tax reform measures put in place in 2002 (Appendix VI).17 Primary spending-to-GDP is to fall marginally, as current expenditure will remain under strict control with no generalized wage or pension increase.

24. Protecting the most vulnerable of the population remains high on the authorities’ agenda. The authorities are working with multilateral institutions to improve the efficiency and targeting of social programs (Appendices IV and V). Social expenditure (as a percentage of total budget outlays) is to rise for the second year in a row (Table 12).

Table 12.Peru: Functional Classification of Budget Expenditure 1/2/
BudgetPrel.

Budget
19992000200120022003
(In percent of GDP)
Total19.018.918.217.821.1
Planning and administration4.75.04.74.75.4
Debt service3.43.93.63.84.6
Administration1.21.11.11.00.8
Pensions and social assistance4.14.14.24.15.0
Pensions3.03.33.23.13.0
Other social assistance1.00.81.01.02.0
Education3.02.92.83.03.1
Preprimary0.30.20.20.30.2
Primary1.11.01.01.01.0
Secondary0.70.70.80.80.9
Tertiary0.60.50.50.50.6
Other0.30.50.40.30.4
Defense and national security2.82.92.52.12.1
Health and water1.51.61.61.72.2
Water and sewage0.20.20.10.10.7
Healthcare services1.41.41.51.61.5
Transportation1.00.70.70.71.2
Agriculture0.70.70.60.50.7
Justice0.40.40.40.40.4
Energy and natural resources0.20.10.10.10.3
Foreign relations0.20.20.20.20.2
Legislative0.10.10.10.10.1
Housing and urban development0.10.10.10.10.0
Industry, commerce, and services0.10.10.10.10.0
Fishing0.10.10.10.10.0
Communications0.00.00.00.00.0
Employment0.00.00.00.00.1
Memorandum items:
Total social expenditure7.06.86.97.28.9
Budgetary social expenditure 3/5.55.35.45.77.3
ES SALUD 4/1.41.51.51.51.5
Fonavi 5/0.10.00.00.00.0
Source: Ministry of Economy and Finance.

Budget coverage includes central government and some autonomous agencies (i.e. ONP, FCR, FONAHPU).

The 2003 budget includes for the first time an estimate of tax expenditure (1.7 percent of GDP).

Includes education, health and sanitation, and other social assistance.

Total expenditure by Essalud, the public health insurance administration.

Net operations of the national housing fund (Fonavi), loan disbursements and amortizations received.

Source: Ministry of Economy and Finance.

Budget coverage includes central government and some autonomous agencies (i.e. ONP, FCR, FONAHPU).

The 2003 budget includes for the first time an estimate of tax expenditure (1.7 percent of GDP).

Includes education, health and sanitation, and other social assistance.

Total expenditure by Essalud, the public health insurance administration.

Net operations of the national housing fund (Fonavi), loan disbursements and amortizations received.

25. The fiscal deficit in 2003 will be financed mainly from external sources(Table 13). World Bank, IDB, and Andean Development Corporation (CAF) disbursements are projected at about the same levels as in 2002, as is the amount of debt to be placed in international capital markets (excluding the impact of the debt swap). Total net external financing in 2003 is projected at US$750 million, or 1.3 percent of GDP. The remaining financing (0.6 percent of GDP) would come from receipts for past privatizations, operating concessions granted under the government’s PIPP, and bond placements in the domestic market.

Table 13.Peru: Financing of the Combined Public Sector
Prog.Rev. Prog.Prog.Rev. Prog.
2002200220032003
(In millions of US. dollars)
Combined balance-1,060-1,284-770-1,118
Financing1,0601,2847701,118
Net External4101,186183753
Disbursements 1/1,2502,0561,2501,800
Bonds 1/09890700
Multilateral1,025774992817
Bilaterals and other225293258283
Amortizations 1/-862-925-1,091-1,074
Condonations22552427
Privatization700400700400
Net Domestic financing-50-302-113-35
Bonds452267667345
Amortizations-147-125-381-357
Net deposits-355-452-398-23
Of which: Central government-121-424-11445
(In percent of GDP)
Combined balance-1.9-2.3-1.4-1.9
Financing1.92.31.41.9
Net External0.72.10.31.3
Disbursements 1/2.23.72.13.1
Bonds 1/0.01.80.01.2
Multilateral1.81.41.71.4
Bilateral and other0.40.50.40.5
Amortizations 1/-1.5-1.7-1.8-1.9
Condonations0.00.10.00.0
Privatization1.20.71.20.7
Net Domestic financing-0.0-0.5-0.1-0.1
Bonds0.80.51.10.6
Amortizations-0.3-0.2-0.6-0.6
Net deposits-0.5-0.8-0.6-0.0
Of which: Central government-0.2-0.7-0.20.1
Sources: Central Reserve Bank of Peru; Ministry of Economy and Finance; and Fund staff estimates.

Excludes the Brady bond swap of US$923 million carried out in early 2002.

Sources: Central Reserve Bank of Peru; Ministry of Economy and Finance; and Fund staff estimates.

Excludes the Brady bond swap of US$923 million carried out in early 2002.

26. The staff cautioned that in the current international capital market environment and given Peru’s relatively high public debt-to-GDP ratio, the authorities should have a well-defined contingency strategy for potential shortfalls in external financing. Such a strategy might need to include measures to reduce the fiscal deficit further. The authorities noted that Peru had maintained access to international capital markets, pointing to their recent US$500 million bond placement.18 They added that, if markets were temporarily closed, they could make up the shortfall by tapping emergency lending facilities at the World Bank and IDB, additional access to CAF funds, and by using part of government deposits built-up in 2002 (mainly at the central bank).19 They believed that a temporary market closure should not necessitate a change in their fiscal strategy, since contingency financing was available, but noted that a longer-term reduction in market access would lead them to tighten the medium-term fiscal framework. The authorities reaffirmed their commitment not to use resources of the pension reserve fund held at the central bank (as part of official reserves) for financing the fiscal deficit.

27. Reactivating the domestic government bond market is essential for improving public debt management over the medium term. When spreads on Peruvian paper began to rise in the second quarter of this year, the authorities took actions that raised perceptions among market participants that they were trying to manipulate the market.20 As a result, the market has been dormant since May. The staff stressed that, with significant domestic debt coming due next year, restoring market confidence was critical. The authorities explained that the actions taken were aimed at addressing collusive behavior of market participants and demands for interest rates that were not in line with market conditions. Nevertheless, they agreed with the staff on the need to reactivate the market and, to this end, will introduce a system of primary dealers and other steps described in the attached letter of intent (LOI, paragraph 13).21

28. The staff supported the authorities’ continuing efforts to encourage private sector participation in the operations of state enterprises, through the granting of operating concessions, management contracts, and strategic partnerships. A broad effort has been made to ensure that such a program has popular support (LOI, paragraph 11). The staff noted that in terms of improving economic efficiency, operating concessions were good substitutes for outright privatization, but that they generally yielded less up-front revenue. For 2003, proceeds from the PIPP are expected to yield US$400 million, about the same as in 2002.22

29. In 2003-04, the authorities intend to introduce the key element of their comprehensive tax reform plan—elimination of certain regional and sectoral tax exemptions. The objectives are to increase efficiency, facilitate tax administration, and raise close to 1 percent of GDP in annual tax revenues over the medium term. The authorities intend to eliminate those exemptions which are not needed to match tax incentive schemes in neighboring countries and which are not important for low-income households (see Appendix X for a list of existing exemptions). The staff urged the authorities to move quickly with eliminating most exemptions, but the authorities felt that in the current political circumstances, they could not take unilateral actions that would have important repercussions for the regions. Rather, they were aiming at phasing out regional and sectoral tax exemptions in consultation with the incoming regional administrations (LOI, paragraph 12). Increased tax collections in the affected regions (resulting from the phase-out of exemptions) would be earmarked for those regions to spend on infrastructure. Full implementation of the reform is envisaged by end-2004, with about half of the targeted exemptions (in terms of their revenue cost) to be eliminated by end-2003. Staff also urged the authorities to resist any future pressures for tax amnesties, as their history in Peru (and other countries) clearly demonstrates their long-term costs of reduced taxpayer compliance.

30. The staff advised the authorities to carry out the decentralization program in a cautious and fiscally neutral manner. Staff encouraged them to work closely with IDB and World Bank experts and noted the usefulness of pilot programs to test the transfer of expenditure responsibilities. The authorities agreed and explained that they would first transfer social programs to the regions and, once the transfer mechanism was functioning in a fiscally neutral manner, transfer the larger health and education programs. They noted that fiscal discipline in the regions would be aided by the revised fiscal responsibility law, which restricts sub-national governments’ external borrowing and applies to them the national fiscal rules.

31. The staff supported the authorities’ plans to continue pension reform in 2003. To improve the finances of the public pension plans the authorities intend to streamline further the benefit structure of the Cédula Viva preferential pension system, with a view to eventually unifying the main public pension systems. They also intend to expand investment opportunities of private pension funds, while working with those funds to lower operating costs.23 There was agreement that a current proposal in congress to lower the retirement age in the public pension system would undermine the public pension system’s finances and imply substantial fiscal costs, and the authorities said they were working with congress to prevent such a reduction.

B. Monetary and Financial Sector Policies

32. The staff supported the current stance of monetary policy and the authorities’ inflation-targeting framework. The staff viewed the 1.5-3.5 percent target band as an appropriate medium-term objective and welcomed the recent tightening of monetary policy in response to exchange market pressures and the resulting risks to the inflation target.

33. Falling interest rates in 2002 have not translated into a noticeable increase in bank credit. The authorities attributed this mainly to banks’ continuing reluctance to lend to other than the most high-quality borrowers, as the banks had just gone through a difficult period of strengthening their balance sheets. They pointed out that improving bank profitability should soon allow banks to start widening their client base.

34. The authorities agreed with the staff that reducing dollarization is an important medium-term goal. They noted that this could only be achieved gradually and in the context of continued prudent macroeconomic policies. In the meantime, containing the risks associated with dollarization was a priority, and they noted the importance of high official reserves to this end. In addition, they explained that reducing dollarization would be aided by their plans to develop domestic capital markets (supported by the World Bank) and stressed the importance of maintaining a sound regulatory environment for dollar lending. The staff concurred, noting that about one-third of official reserves reflected reserve requirements on dollar deposits, and recommended that earlier plans to restructure those reserve requirements (which would likely have led to a reduction in total reserve requirements) not be implemented at this time. The authorities assured the staff that reserve requirements would continue to be managed prudently to ensure a high level of reserve coverage of dollar deposits.

35. The staff welcomed the authorities’ intention to continue strengthening bank supervision. The SBS is analyzing the credit risk from foreign-currency lending by banks and the associated exposure to exchange rate changes and, if necessary, stands ready to issue norms to strengthen the management of those risks. The staff welcomed the planned legislation to grant legal protection to bank supervisors, and urged the authorities to implement other FSAP recommendations (Appendix IX) on reinforcing capital requirements and strengthening the system of prompt corrective actions. The authorities explained that the SBS had recently proposed to congress an increase in capital requirements, but felt that current regulations on corrective actions were more than adequate. The staff welcomed the authorities’ commitment not to use public funds to create new lending institutions (leaving financial intermediation to private institutions supervised by the SBS) and to close the consumer lending program of Banco de la Nación at end-2002. The authorities also pointed out that the second-tier development bank, Cofide, would continue limiting its lending operations to channeling financial resources to banks for on-lending to the private sector (LOI, paragraph 9).

C. External Sector Policies and Issues

36. The exchange rate will continue to float, with intervention only in the spot market to smooth volatility. The authorities and the staff agreed that exchange rate flexibility has served the economy well in adjusting to external shocks and maintaining competitiveness. The staff supported the moderate intervention and monetary tightening used to combat the exchange rate pressures in August/September, but questioned the recent decision by the central bank to issue exchange-rate indexed certificates as a means of providing a hedge for banks in their forward operations. This, the staff pointed out, was functionally very similar to intervention in the forward exchange market.24 The authorities noted that the purpose of the indexed certificates was to reduce pressures in the spot exchange market, and that they would only be issued at appropriate times. MAE provided technical assistance (in mid-October) on the optimal use of these certificates. While noting the instrument’s potential to smooth volatility in the spot exchange market, it was recommended to strictly limit their use to ensure that they do not become a general investment vehicle. In line with staff recommendations, these instruments have been included in the statistics of net international reserves.

37. The authorities pointed out that Peru’s vulnerability to external shocks had been well-contained so far. They attributed this to sound macroeconomic fundamentals, the high level of official reserve coverage of dollar deposits and short-term external debt (reflecting in part the sharp reduction in bank‘s short-term foreign liabilities since 1998, seeBox 2), and limited regional trade links. Furthermore, they noted that the public sector’s external financing needs could be largely covered by official creditors, and that many of the private firms that had access to foreign financing were subsidiaries of large multinational corporations.

38. The staff agreed with the authorities that Peru’s exposure to sudden shifts in market sentiment toward the region had been limited so far, but noted that a further deterioration in the regional situation would not leave it unaffected. In particular, growth would suffer as private investment (both foreign and domestic) would likely fail to recover if capital inflows dried up. The authorities explained that part of the adjustment to any reduction in private capital inflows would come through the exchange rate, but a tightening of the monetary policy stance and some limited use of international reserves would also likely be required. They saw the high level of reserves as providing some room for such action. As noted, the government would likely adhere to its fiscal plan in the short term, but would be prepared to tighten the fiscal stance in case of a prolonged shock.

39. The staff welcomed the authorities’ commitment to continuing trade liberalization and urged them to support HIPC assistance for Nicaragua. Peru has an open trading regime (rated 2 on the 1-10 scale of the Fund’s trade restrictiveness index), with a trade-weighted average tariff rate of 10.7 percent25 and a trading system free of quantitative restrictions. Peru is presently negotiating with members of the Andean Economic Community (CAN) on a common external tariff. The staff cautioned the authorities that the trade negotiations within the CAN might lead to a rise in trade protection. The authorities explained that their medium-term trade priority was to participate in a hemispheric free trade area, and in this context it would be best if Peru was part of the CAN negotiating bloc. On HIPC assistance, the authorities did not believe that the current political and economic environment in Peru would allow them to garner the support necessary to grant HIPC assistance to Nicaragua.

D. Labor Markets Issues

40. The staff expressed concern that some recent changes in labor market regulations would reduce flexibility and that there no longer existed an effective unemployment safety net. Conditions have been tightened on firms’ abilities to outsource labor needs, standardize overtime and bonus pay rules, and lay off workers. The staff pointed out that a less flexible labor market would reduce the growth elasticity of employment, which would make reducing the high level of unemployment and underemployment more difficult.26 Moreover, the staff noted that since late-2000 workers had been left with no protection in the event of job loss as a result of legal norms that effectively shifted funding for the unemployment protection scheme to direct payments to workers.27 The authorities said that labor-market flexibility had not been compromised, noting that the measures on outsourcing and pay rules aimed at protecting workers and had the support of the International Labor Organization. In their view, a recent constitutional court ruling against collective dismissals was case-specific, and an omnibus labor bill presently in congress was likely to reaffirm the relatively flexible labor market situation. In addition, the authorities informed the staff that they were considering proposals to provide unemployment insurance protection, including a return to the original CTS, but that no final decision had been taken.

IV. StaffAppraisal

41. Peru’s economic performance in 2002 has been encouraging. Despite a deteriorating external environment and a difficult political situation at home, growth is recovering, inflation is low, and the external position is robust. Macroeconomic performance has been broadly in line with the program, and progress has been made with structural reforms. All but one end-September quantitative performance criteria were observed, as were most structural benchmarks. Domestic political considerations led to a reorientation of the privatization agenda under the Private Investment Promotion Program (PIPP) and of the strategy for eliminating regional and sectoral tax exemptions.

42. Continued implementation of sound macroeconomic policies and structural reforms should allow Peru to continue to resist adverse regional and other external developments. Maintaining a sound macroeconomic framework would keep public-debt dynamics under control and international reserves at comfortable levels, creating the conditions for sustained rapid growth and a recovery in private investment. Although external debt and debt-service obligations are relatively high, they should decline progressively under the policy framework described above.

43. While the baseline medium-term outlook is favorable, there are risks. In articular, the high degree of dollarization and the relatively large public debt imply that Peru will remain vulnerable to adverse shocks for some time. A severe but short-term financial shock would affect growth as the anticipated recovery in private investment would likely be delayed; such a shock would probably require some tightening of monetary policy, but contingency financing plans could allow the fiscal program to proceed without abrupt changes. A more permanent financial shock would require a tightening of the fiscal stance. Given the external environment, and the risk that the domestic political situation poses to tax reform and decentralization (and thus to medium-term sustainability), the authorities should develop a contingency plan for fiscal measures that could be implemented if needed.

44. The revised fiscal program balances the need to reduce the deficit while supporting the recovery. Reducing the deficit is needed to impart credibility to the country’s medium-term fiscal deficit target and avoid an increase in the public debt-to-GDP ratio. This is being done in a gradual manner so as not to adversely impact economic growth. It is important that the authorities continue to work with the World Bank and IDB to improve the quality of public expenditure, to ensure that the most vulnerable of the population are well protected, and to increase budget flexibility to absorb unanticipated expenditure shocks (such as those related to recent court rulings).

45. Comprehensive tax reform is key to putting the public finances on a sustainable basis. Tax policy and administration measures implemented in 2002 will improve the overall efficiency and equity of the tax system, although the recent tax amnesty again risks undermining future tax discipline. The reform is to be completed over the next two years by the elimination of regional and sectoral tax exemptions. The staff hopes that the authorities’ phased approach to eliminating those exemptions will help them reach agreements with regional authorities. However, there is also a risk that the reform will lose momentum under this approach, and the authorities will need to be persistent in pursuit of this key reform.

46. The domestic bond market needs to be reactivated by improving the transparency and efficiency of the auction process. The 2003 fiscal program relies on an increase in the placement of government bonds in the domestic market, consistent with rates of placement made in early 2002 when the market was functioning well.

47. The decision to seek alternatives to privatization should not necessarily mean less efficiency gains. The reorientation of the PIPP from asset sales toward operating concessions and other forms of private-sector participation in state enterprise operations was a pragmatic response to growing protests against privatization. Operating concessions could generate similar investment commitments to privatization, but will generally result in lower immediate receipts for the government.

48. Decentralization needs to be carried out cautiously to ensure that its impact is fiscally neutral. While the authorities’ strategy, supported by the World Bank and IDB, appears to be sound, the experience in other countries has shown that there are considerable fiscal risks in decentralization. Pilot programs could serve as useful tests of the fiscal impact. In addition, swift passage of the revised fiscal responsibility law is important, as it contains important regulations on regional and local government finances. Maintaining a political consensus with the regions will be crucial for an orderly implementation of decentralization.

49. The authorities’ intention to continue reforming public and private pension systems is welcome. Measures taken to date, and continued efforts to streamline benefits under the Cédula Viva system with a view toward unifying the main public pension systems, will serve to reduce the net present value of the pension system’s liabilities and improve its equity. In contrast, a proposal to lower the retirement age in the public pension system would have significant negative consequences for the fiscal finances and should be resisted.

50. Staff supports the inflation-targeting framework for monetary policy, with a target band of 1.5-3.5 percent over the medium term, and encourages the authorities to continue refining the inflation forecast and to strengthen its integration with the monetary policy decision-making process. The staff agrees with the authorities that reducing dollarization is a key goal that, while likely requiring time, will depend on continued pursuit of prudent macroeconomic policies, aided by strong bank supervision and development of the domestic capital market.

51. The high level of official reserves is a key factor in Peru’s ability to avoid the contagion that has affected other highly-dollarized economies in the region. The staff welcomes the decisions to maintain reserve requirements on U.S. dollar deposits at the present level and to avoid recourse to dollar deposits of the pension reserve fund held at the central bank to finance fiscal operations.

52. The position of most banks has strengthened over the past year, and the authorities’ commitment to further enhance prudential oversight is welcome. Particularly important are plans to evaluate the credit risk of banks derived from foreign-currency lending and to grant legal protection to bank supervisors. The staff commends the authorities’ continued intention to leave financial intermediation activities to private sector institutions under SBS supervision.

53. The flexible exchange rate system has served Peru well in adjusting to external shocks. The response in August/September to pressures in the foreign exchange market, combining monetary tightening and modest intervention in the foreign exchange market, was appropriate. The policy of not intervening directly in the forward exchange market should continue, and use of the new exchange rate-indexed Sol-denominated central bank certificates should be strictly limited.

54. The staff commends the authorities’ continuing commitment to an open trade and payments regime. The authorities should resist proposals in the trade negotiations within the Andean Community that might lead to a rise in trade protection.

55. The authorities’ intention to maintain the current relatively flexible system of labor market norms is welcome. In light of the high level of underemployment and unemployment, it is important that the new legal framework for labor markets maintain flexibility, as any reduction would be detrimental to employment growth and poverty reduction. In addition, the authorities should implement as soon as possible an adequate unemployment insurance system.

56. Economic statistics are timely and broadly adequate for program monitoring and surveillance purposes. The authorities have improved banking data, and the inflation targeting framework adopted in January 2002 has increased the transparency of monetary policy. The ROSC fiscal transparency module and planned ROSC data module are welcome steps to improve information dissemination, but fiscal decentralization will require efforts to compile and report additional fiscal data. The recent decision by the National Statistics Office to rebase GDP figures to 2001 should not pose a problem in monitoring or surveillance, as the authorities will continue to publish quarterly and annual GDP data.

57. In summary, Peru has performed well under the program supported by the Stand-By Arrangement, and the staff recommends completion of the first review. The overall stance of macroeconomic policy is appropriate, and staff is confident that the authorities will continue to adjust policies as needed to achieve the objectives of the program. Because monetary policy has been consistent with the central bank’s inflation-targeting framework and in line with the program, the staff supports the authorities’ request for a waiver for the nonobservance of the end-September performance criterion on NDA and the replacement of the performance criterion on NDA by a consultation mechanism based on inflation. In addition, the staff supports the authorities’ request to modify the fiscal performance criterion and all privatization-related adjusters for end-2002.

58. It is recommended that the next Article IV consultation with Peru will be held on a 24-month consultation cycle in accordance with the Board decision DEC/12794 adopted on July 15, 2002.

APPENDIX I Peru: Fund Relations

(As of October 31,2002)

I. Membership Status: Joined 12/31/1945; accepted Article VIII status on February 15, 1961.

II. General Resources Account

SDR MillionPercent Quota
Quota638.40100.00
Fund holdings of currency812.37127.25

III. SDR Department

SDR MillionPercent Allocation
Net cumulative allocation91.32100.00
Holdings2.552.80

IV. Outstanding Purchases and Loans

SDR MillionPercent Quota
Extended arrangements173.9327.25

v. Financial Arrangements

Type of ArrangementApproval

Date
Expiration

Date
Amount

Approved

(SDR Million)
Amount

Drawn

(SDR Million)
Stand-By2/01/022/29/04255.000.00
Stand-By3/12/011/31/02128.000.00
EFF6/24/992/08/01383.000.00
EFF7/01/963/31/99300.20160.50
EFF3/18/933/17/961,018.10642.70

VI. Projected Obligations to the Fund(SDR Million; based on existing use of resources and present holdings of SDRs):

OverdueForthcoming
8/31/0220022003200420052006
Principal0080.3126.7526.7526.75
Charges/interest02.015.694.333.552.78
Total02.0186.0031.0830.3029.53

VII. Safeguard Assessments

Under the Fund’s safeguards assessment policy, the Central Reserve Bank of Peru is subject to a full safeguards assessment with respect to the Stand-By Arrangement approved on February 1,2002, and scheduled to expire on February 29, 2004.

A safeguards assessment was completed on July 26, 2001. The assessment identified certain weaknesses (most notably with the central bank’s implementation of International Accounting Standards) and provided recommendations to address them. The Central Reserve Bank of Peru has proceeded to implement most of the recommendations.

VIII. Exchange Arrangements

Peru maintains a unified, floating exchange rate. On November 22, 2002, the average of interbank buying and selling rates was 3.58 new soles per U.S. dollar. The central government maintains external payments arrears to unguaranteed suppliers, some of whom are in discussions with the government, while the rest have not been located. Peru maintains a clearing arrangement with Malaysia.

IX. Last Article IV Consultation

The 2000 Article IV consultation was concluded on March 12, 2001 (EBS/01/25).

X. FSAP Participation

Several joint Fund-Bank missions visited Peru in the period September 2000-January 2001 to conduct an FSAP for Peru. The corresponding FSSA report (SM/01/75 dated February 28, 2001) was discussed by the Executive Board on March 12,2001.

XI. Technical Assistance

DepartmentDatePurpose
FADNovember 1999Fiscal rules
June 2000, September 2002Tax policy and administration
October 2002Fiscal ROSC
MAEApril 1998Modernization of the payments system
January 2000Forward foreign exchange markets
September, October, November 2000, January 2001Financial sector assessment
March, 2002Monetary operations and government securities market
May 2002Inflation targeting
August 2002Accounting and organizational issues
October 2002Foreign exchange operations
STAJanuary 1998 and October 1999National account statistics, new base year for the national account series
TREMarch 1999Central bank accounting.

XII. Resident Representative

Mr. Ricardo Velloso started his assignment as the Fund Resident Representative in Peru in July 2001.

APPENDIX II Peru: Statistical Issues

Peru is in observance of the Special Data Dissemination Standard (SDDS) and meets the specifications for coverage, periodicity, and timeliness of the data categories and the dissemination of the advance release calendars, and the metadata have been posted on the Fund’s Dissemination Standards Bulletin Board.

I. Real Sector

In June 2000, the authorities published a revised GDP series using 1994 as the base year. However, the National Statistics Office (INEI) recently announced its intention to produce a new GDP series using 2001 as the base year, which would become available in mid-2003. In the meantime, INEI will carry on with the publication of base-year 1994 GDP data.

The authorities monitor labor market developments through four indicators: open unemployment, underemployment, employment, and remunerations. The quality of these indicators has improved over the last two years. However, wage data comes with a relatively long delay; the nationwide unemployment and underemployment situation is surveyed only once a year; and labor productivity data is only published at the time of adjustments to electricity and telecommunications tariffs.

II. Fiscal Sector

For the consolidated central government data, revenues are reported on a cash basis, while expenditures are reported on an accrual basis. The authorities have reported data on the operations of the consolidated central, regional and local governments and debt up to 2001 for publication in the Government Finance Statistics Yearbook (GFSY). The authorities are preparing information on the components of consolidated central government expenditures by function. The International Financial Statistics (IFS) has published fiscal data through July 2002.

The coverage of national budget accounting is narrower than the fiscal accounting carried out in the program.

III. Monetary Sector

The central bank of Peru (BCRP) is responsible for the compilation and dissemination of monetary sector statistics. The BCRP prepares and publishes the analytical accounts of the banking system and of the central bank in line with international standards in terms of coverage and periodicity.

IV. External Sector

The central bank of Peru (BCRP) is responsible for the compilation and dissemination of balance of payments and international investment position statistics. The BCRP prepares quarterly data largely in line with the framework of the Balance of Payments Manual, Fifth Edition (BPM5).

Trade data are provided by Customs. Import data is recorded on the date on which the customs documents are numbered (which is close to the date of clearance), while exports are recorded on the shipment date. Data on exports and imports from Customs are supplemented by other reports. For example, import data is supplemented by imports into the Tacna Special Processing Area.

Data on services are mostly based on the BCRP’s quarterly surveys reported by resident operators (e.g. transporters, insurance companies, and telecommunications). Data on other services is mostly based on the Annual Services, Foreign Investment and External Debt Survey (SFIED).

For income, the BCRP mostly relies on the quarterly Foreign Investment and External Debt Survey (QFIED), which also provides information used to calculate direct investment, portfolio investment, and other private nonfinancial investment. In addition, portfolio investment liabilities are obtained from the Lima Stock Exchange. Financial investment data are calculated from quarterly-position data reports on commercial bank transactions with nonresident correspondents and from the monetary authority. Data on short-term loans to the private sector are provided by financial institutions. Information for the private financial accounts and income accounts is supplemented by the annual SFIED. The Ministry of Economy and Finance provides information on general-government external debt (disbursements, repayments, and interest payments).

Quarterly statistics are considered preliminary until final annual data is available. Definitive statistics of other services, direct investment and other private sector investment are available 18 months after the end of the referred period.

Regarding international reserves, Peru has been reporting since August 2001 weekly data in accordance with the Operational Guidelines for Data Template on International Reserves and Foreign Currency Liquidity. For the external-debt data category, the SDDS transition period ends on March 2003. As an SDDS subscriber, Peru will disseminate quarterly data on external debt with a one-quarter lag by end-September 2003.

Peru: Core Statistical IndicatorsAs of October 31, 2002
Exchange RateInternational Reserves 1/Central Bank Balance SheetReserve/Base MoneyBroad MoneyInterest RatesConsumer Price IndexExports/ImportsCurrent Account BalanceOverall Government Balance 2/GDP/GNPExternal Debt 3/Debt Service 3/
Date of Latest Observation10/31/200210/30/200210/22/200210/22/20029/30/200210/31/20029/20028/2002Q2/2002Q2/20028/2002Q2/2002Q2/2002
Date Received10/31/200210/31/200210/25/200210/25/200210/25/200210/31/200210/4/200210/11/20028/23/20028/23/200210/11/20028/23/20028/23/2002
Frequency of Data 4/DDWWWDMMQQMQQ
Frequency of Reporting 4/DDWWWDMMQ0MQQ
Source of Update 5/BBBBBBBBBBBBB
Mode of Reporting 6/EEMEEEMMMMMMM
Confidentiality 7/CCCCCCCCCCCCC
Frequency of Publication 4/DDWWwDMMQQMQQ

Data refer to net international reserves. Reserve template data are reported weekly, with a lag of 1 week, and are in full compliance with template standards.

Refers to combined public sector deficit, including general government, public enterprises, and the operating balance of the central bank.

Data are reported quarterly with a lag of 2 months, and cover private and public sector debt and debt-service.

D=Daily; W=Weekly; M=Monthly; Q=Quarterly; and A=Annual.

B=Central bank, F=Ministry of Finance; O=other official agency.

E=Electronic, and M=mail.

C=For unrestricted use.

Data refer to net international reserves. Reserve template data are reported weekly, with a lag of 1 week, and are in full compliance with template standards.

Refers to combined public sector deficit, including general government, public enterprises, and the operating balance of the central bank.

Data are reported quarterly with a lag of 2 months, and cover private and public sector debt and debt-service.

D=Daily; W=Weekly; M=Monthly; Q=Quarterly; and A=Annual.

B=Central bank, F=Ministry of Finance; O=other official agency.

E=Electronic, and M=mail.

C=For unrestricted use.

APPENDIX III Peru: Recent Tax Amnesties

In recent years, the Peruvian authorities have approved four general tax amnesties(including special payment agreements—fraccionamientos). The broad scope of the amnesties, their high frequency and easing conditions over time, have signaled to taxpayers that amnesties are not “one-time events” and that noncompliance can be advantageous. The amnesties (Table 1) have covered taxpayers with tax obligations under previous amnesties or tax obligations under civil tax litigation. Penalties have been abated as have interest payments. Tax liabilities have been reduced considerably through frequent re-determination and discounts for full payment. Table 2 compares two such amnesties and shows that over time more taxpayers have benefited from successive amnesties, while repayments have been extended over longer periods of time.

Table 1.
Tax Amnesty ProgramSpecial Payment Agreements Regime-RFE1Special Regimen of Tax Payment Agreements -REFT2Special Payment System of Tax Debts-SEAP3Recovery Through Tax Debt Recognition-RESIT4
Scope of the amnestyTax obligations as of end-Aug. 1996 with the tax agency (SUNAT), customs (SUNAD), social security (ONP), the housing national fund (FONAVI), and the state commercial bank (Banco de la Nación) (irrespective of one’s tax obligation status).Originally: tax obligations as of end-July 2000 with SUNAT, SUNAD, ONP, FONAVI, Banco de la Nación.

Debt due to enterprises under restructuring. Date later modified to end-Aug. 2000.
Tax obligations as of end-Aug. 2000 with SUNAT, SUNAD, ONP, FONAVI, Banco de la Nacion. Debt due to enterprises under restructuring.Tax obligations as of Dec. 2001 with SUNAT, SUNAD, ONP, FONAVI, Banco de la Nación. Debt due to enterprises under restructuring.
BenefitsRe-determination of tax liability by indexing the original debt to inflation. Elimination of all penalties, surcharges or interest.Re-determination of the liability by indexing the original debt to inflation or a rate of 6 percent per annum (whichever is lower). Elimination of all penalties, surcharges or interest.Re-determination of the liability by indexing the original debt to inflation or a rate of 6 percent per annum (whichever is lower). Elimination of all penalties, surcharges or interest.Re-determination of the liability by indexing the original debt to inflation or a rate of 6 percent per annum (whichever is lower). Elimination of all penalties, surcharges or interest.
GuaranteesRequired for debt over S./100,000.Not requiredNot requiredNot required
Interest rate22 percent nominal interest rate on the balance at the end of each year.15 percent nominal interest rate on the balance at the end of each year.15 percent nominal interest rate on the balance at the end of each year.8 percent effective interest rate on the balance at the end of each year.
Payment schemesFull payment or balance to be paid over a period of 7 years.(1) Five percent discount for payment in full, later modified to 10 percent.

(2) Five percent down payment and balance to be paid over a period of 10 years.
(1)10 percent discount for payment in full.

(2) 5 percent down payment and balance to be paid over a period of 10 years.
(1) 10 percent discount for payment in full.

(2) 5 percent down payment and balance to be paid over a period of 10 years.

Decree 848 (September 1996, with several modifications in 1998 and 1999).

Law 27344 (September 2000).

Decree 914 (April 200I).

Law 27681 (March 2002).

Decree 848 (September 1996, with several modifications in 1998 and 1999).

Law 27344 (September 2000).

Decree 914 (April 200I).

Law 27681 (March 2002).

Table 1
Tax Amnesty ProgramSpecial Payment Agreements Regime-RFESpecial Regimen of Tax Payment Agreements -REFTSpecial Payment System of Tax Debts-SEAPRecovery Through Tax Debt Recognition-RESIT
Loss of benefitMissing payments or failing to file returns for two consecutive periods triggers use of collateral first and then interest is charged on unpaid installments. There is no loss of benefits, however, regarding the redetermination of the stock of tax debt owed.Missing payments or failing to file returns for two consecutive periods or more. There is no loss of benefits, however, regarding the redetermination of the stock of tax debt owed.Missing payments or failing to file returns for two consecutive periods. There is no loss of benefits, however, regarding the redetermination of the stock of tax debt owed.Missing payments or failing to file returns for three or more consecutive periods. There is no loss of benefits, however, regarding the redetermination of the stock of tax debt owed.
Source: SUNAT-Peru.
Source: SUNAT-Peru.
Table 2.Comparison of RFE and RESIT Amnesties
RFERESIT
Number of participants50,66053,439
Percentage of new participants6847
Percentage of participants in two (or three) amnesties3253
Total tax obligations to be covered (in percent of GDP)1.41.0
Of which: under payment agreements9396
Percentage of agreements to reach over 6-7 years721
Percentage of agreements to reach over 9-10 years280
Source: SUNAT Peru.
Source: SUNAT Peru.
APPENDIX IV Peru: World Bank Relations

Partnership in Peru’s development strategy

The government’s strategy focuses on attacking poverty through: employment generation, access to health, education, culture and other basic services; and creating a state that serves the people. Key to achieving these goals is to have in place an economic program and institutions ready to buffer the impact of adverse shocks—and thus prevent losing ground in the fight against poverty—while addressing structural sources of poverty. A national accord, signed on July 22, 2002, organizes the government’s tasks into four areas: democracy and the rule of law; competitiveness of the country; equity and social justice; and an efficient, transparent and decentralized state. A group of indicators to monitor progress have been identified in the areas of competitiveness and equity, and additional indicators are expected by the end of this year.

In the area of competitiveness, the government will seek to foster a sustainable economic recovery, by bringing about greater competitiveness of Peru’s private sector. On equity and social justice, it will seek to provide all Peruvians with access to quality health, education, culture and other basic services. Finally, regarding institutionality, it will promote democracy and the rule of law through a more efficient, transparent and decentralized state.

Fifteen indicators and targets have been identified by the government to measure progress in reaching the poverty reduction and growth targets. There is a high coincidence of these indicators with the Millennium Development Goals (MDG), although the government’s 2015 targets are not the same as those identified for the MDG.

Bank Group strategy

To achieve its development strategy, and in light of the high dollar indebtedness of the economy, Peru needs to increase fiscal revenue and exports, strengthen governance and institutions, and eliminate obstacles to firm development The World Bank Group FY03 Country Assistance Strategy (CAS), discussed by the WB Board on September 17, aims at helping the government fulfill these needs by providing support to its fiscal program, national competitiveness program, and social sector program. Assistance will be provided to make safety nets more efficient and create growth opportunities targeted to the poor and to strengthen governance and institutions.

The CAS lending program is for US$180 to US$250 million a year in new lending that would include quick-disbursing programmatic loans. Such loans would depend on the achievement of a set of targets (triggers) related to the tax revenue effort and the implementation of key actions and reforms in public sector management, decentralization, and competitiveness. The lending program would also include lending for specific investment projects for about US$120 million a year.

The principal strategic elements of the CAS are:

  • supporting policy and institutional reforms through a combination of analytical and advisory activities and technical assistance loans. Programmatic loans (in the high-lending case) would support a reform program covering the areas of: public sector management and decentralization; barriers to competitiveness; and social sectors;
  • financing investment programs that have a direct impact on the productive lives of the poor, through a combination of rural and urban development programs, and financing to support the institution of reforms in the social sectors;
  • renewing focus on environmental issues especially linked to health, sustainable use of natural resources, and management of biodiversity; and
  • continuing emphasis on partnerships with civil society, and addressing the inclusion within WBG operations of specific groups such as youth, women, indigenous peoples, and Afro-Peruvians.

The Bank’s non lending services will focus on: (i) in the competitiveness area, poverty-related studies, the development of a rural infrastructure strategy, and analysis of private sector growth issues, including a regional study of privatization and private sector participation experiences; and (ii) in the equity area, environmental health, youth and social development, indigenous learning and knowledge exchange, major sectoral studies in health and education, and activities in the water and sanitation sector, including an assessment of strategies for private sector participation. Finally, additional services will include diagnostic work and policy advice regarding institutional reforms and decentralization.

Bank-Fund collaboration in specific areas

As part of its overall assistance to Peru, the Bank has strengthened its close collaboration with the IMF. Specific examples of joint work have covered the following areas:

  • Financial Sector. A joint FSAL was completed in May 2001, covering: the macro environment, risks and vulnerabilities, safety net, regulations and supervision, public sector asset/liability management, pension system, capital markets, microfinance, rural finance, and corporate restructuring. Follow up technical assistance to implement FSAL recommendations has been provided by both institutions.
  • Public expenditure review (PER). In a joint effort with the IDB, and close collaboration with the IMF, the Bank completed in June a comprehensive diagnosis of, and made policy recommendations for, Peru’s public expenditure management. Several key aspects of the PER underscore the importance of Bank-Fund collaboration, including the need to push forward in restoring fiscal discipline, promoting a shift toward pro-poor programs, and improving the efficiency of public expenditure. Among several topics, the PER developed an innovative public expenditure tracking survey for Peru. Moreover, the Bank and the Fund worked closely in the areas of: tax reform, debt sustainability, and fiscal rules. As part of the PER dissemination activities, the Bank, the IDB, and the Fund organized jointly (in August 2002) a seminar on “Restoring Fiscal Discipline and Poverty Reduction” attended by the new cabinet, the monetary authorities, think-tanks, and the media.
  • Fiscal reforms. In March 2002, in Lima, the Bank and the Fund supported jointly an international seminar (organized by the Ministry of Economy and Finance) on proposals for revising the law on fiscal responsibility and transparency. The seminar was attended by panelists from Chile, Brazil, Argentina, Venezuela and Mexico and has been particularly instrumental for preparing amendments to the current fiscal framework at the onset of decentralization.
  • CAS and preparation of the Programmatic Social Reform Loans (PSRL-I and II). The Bank and the Fund have engaged in an interactive and continuous dialogue on the CAS, implementation of PSRL-I, and preparation of PSRL II. Dialogue has concentrated on the macroeconomic background, setting of triggers, overall loan conditionality, risks, and estimation of the fiscal implications of both operations.

Prepared by World Bank staff. Questions may be addressed to Mr. Jose Lopez-Cálix, Senior Country Economist at 458-1906; or Mr. Eduardo Wallentin, Senior Country Officer at 473-5600.

Statement of World Bank Loans(As of August 12, 2002)
In millions of U.S. Dollars
Loan NumberFiscal Year ApprovedBorrowerPurposeTotal (Net of Cancellation)Undisbursed
Eighty (80) loans fully disbursed 1/3,957.6
Partially disbursed or undisbursed loans:
381101995Republic of PeruLima water rehabilitation and management project (SEDAPAL)150.013.8
461402001Republic of PeruSecond Rural roads rehabilitation and maintenance50.045.5
407601997Republic of PeruIrrigation rehabilitation85.025.3
413001997Republic of PeruSierra national resource management51.07.2
438401999Republic of PeruUrban property rights38.013.8
451902000Republic of PeruAgricultural research and extension9.65.4
453602000Republic of PeruIndigenous people development5.04.6
452702000Republic of PeruHealth reform27.024.5
Total4,373.2
Of which: amount repaid1,952.8
Total outstanding2,420.4
Total undisbursed144.1

Includes the 1979 program loans (US$115 million), 1992 Financial Sector Adjustment Loan (US$400 million), 1992 Trade Policy Loan (US$300 million), and 1992 Structural Adjustment Loan (US$150 million), 1993 Privatization Adjustment Loan (US$250 million), 1997 Pension Reform Adjustment Loan (USS100 million), 1997 DDSR Loan (USS1S3 million), and 1999 Financial Sector Adjustment Loan (US$300 million), and 2001 Programmatic Social Reform Loan (US$100 million).

Includes the 1979 program loans (US$115 million), 1992 Financial Sector Adjustment Loan (US$400 million), 1992 Trade Policy Loan (US$300 million), and 1992 Structural Adjustment Loan (US$150 million), 1993 Privatization Adjustment Loan (US$250 million), 1997 Pension Reform Adjustment Loan (USS100 million), 1997 DDSR Loan (USS1S3 million), and 1999 Financial Sector Adjustment Loan (US$300 million), and 2001 Programmatic Social Reform Loan (US$100 million).

Statement of IFC Investments(As of August 12,2002)In millions of U.S. dollars
LoansEquityQuasi-EquityParticipation

Loans
Total
Total commitments held by IFC161.636.334.095.1327.0
Total disbursed126.736.132.595.1290.4
Source: World Bank.
Source: World Bank.
APPENDIX V Peru: Relations with the Inter-American Development Bank

I. Background

Since 1991 the Inter-American Development Bank (IDB) has played a major role in supporting economic stabilization, structural reforms, and poverty reduction in Peru. Currently, the Bank is financing programs aimed at reforming public finance management, the tax system, and the country’s fiscal institutions; helping the process of decentralization; modernizing the public sector; reducing poverty; creating the conditions for growth in agriculture, protecting the environment; strengthening the health sector; and improving the quality of secondary education. The Bank is also lending directly to the private sector to build infrastructure projects.

II. Lending

Peru’s total outstanding debt with the IDB as of June 30,2002 amounted to US$2,868 million and current commitments (undisbursed balance) amounted to US$667 million, as of August 8, 2002, corresponding to 16 loans currently in execution. The tentative lending program for 2002 through mid-2003 includes eleven loan operations for an estimated amount of US$687.5 million.

III. Recent economic and sector work

A comprehensive review of major economic, social, and institutional issues was carried out in the process of preparing the Strategy Paper for Peru, the document that lays out the Bank’s strategy for the 2002-06 period. In addition, a Public Expenditure Review (PER) was also carried out, as a joint effort with the World Bank, and was completed in June 2002.

IV. Nonreimbursable technical cooperation

In the last several years, the IDB has extended a number of grants for institutional building programs through the following institutions: SUNAT (tax administration), SUNAD (customs), FONCODES (social programs), Congress, the Ministry of Finance and the Economy, the Republic’s General Comptroller, the Institute for the Defense of Competition and Intellectual Property, municipal savings banks, and financial institutions. Peru has also received grants to establish an environmental authority, for studies on pollution in the Mantaro Valley, and for a number of social programs. In addition, the Bank has provided resources to the Multilateral Investment Fund (MIF) to finance private sector projects.

I. IDB Loans By Sector as of August 8,2002(In millions of U.S. dollars)
CommitmentsDisbursementsUndisbursed

Amounts
Agriculture and social development23.31.222.1
Education187.079.8107.2
Infrastructure50.05.045.0
Multi sector200.0123.976.1
Population, health and nutrition226.8181.045.8
Public sector management320.9210.0110.8
Urban development300.051.8248.2
Water supply and sewerage45.624.720.9
Grand total1,353.6677.3676.3
II. IDB Loan Transactions as of August 8,2002(In millions of U.S. dollars)
199719981999200020012002 (p)Total (1997-2002)
a. Disbursements585.3299.6485.5350.7378.0347.12,446.2
b. Amortization107.5106.5104.2353.2113.5169.5954.5
c. Net disbursements (a-b)477.8193.1381.3-2.6264.5177.61,491.7
APPENDIX VI Peru: 2002 Tax Reform

The tax reform in 2002 included tax policy and tax administration measures. Tax policy measures were intended to improve the neutrality of the tax system and increase tax bases. Measures concentrated on: (i) income taxes (which will take effect in 2003); (ii) elimination (or restriction) of some VAT exemptions; and (iii) increase in the kerosene excise. On tax administration, measures aimed at reducing tax evasion by: (i) introducing various systems of VAT withholding; (ii) intensifying the control of tax collection, refunds and rebates; and (iii) ensuring the collection of tax debts from government’s suppliers and private companies. As a result of the measures implemented, tax revenue is expected to increase by 0.2 percent of GDP in the second half of 2002 and 0.8 percent of GDP in 2003 (see attached Table).1

Tax policy

Income tax

  • A new minimum income tax advance payment scheme for taxpayers with net assets above approximately US$135,000 requires advance payments based on the greater of the past year’s earnings or a percentage of net assets (which would rise with the level of net assets and would range from 0.25 percent to 1.5 percent).
  • Eliminate from allowable deductions under the corporate income tax, automobile purchases for executives and restaurant expenses.
  • Collect taxes from profits made by mutual-fund investors.
  • Increase the maximum marginal income tax rate from 27 to 30 percent.2
  • Introduce an income tax on pensions above 10 tax index units (UTT), currently about US$8,300, under the preferential public pensions plan (Cedula Viva, Decree 20530)2
  • Create a 6 percent income tax on presumptive rental income from second homes.2
  • Revamp the strategy in granting tax-stability contracts to exclude tax benefits and incentives and to charge a 2 percent premium for such contracts.2

VAT

  • Eliminate VAT exemption on fertilizers(for 57 out of 60 agricultural inputs).
  • Restrict the VAT exemption for cultural events. The Ministries of Finance and Culture will establish on a case-by-case basis when a public performance can be considered a cultural event and thus be exempted of the VAT.2

Fuel excise

  • Increase kerosene excise by 80 percent to partially reduce the difference with diesel excise.

Tax administration

Various VAT withholding mechanisms are being established to reduce the evasion on VAT collection. Specifically, a portion of the VAT will be withheld by:

  • Large buyers in transactions of agricultural products characterized by a high level of informality (rice, sugar and alcohol). Suppliers are to open a bank account—exclusively used for tax payments—in the state-owned Banco de la Nación. Prior to delivery, buyers must deposit 10 percent of the sale price into these accounts (products cannot be delivered without the bank deposit receipt).3
  • Large taxpayers (1,200 in total) in transactions with their suppliers. These large taxpayers must withhold 6 percent at the payment stage of every purchase, when transactions exceed a minimum amount (of around US$200). The system applies to suppliers not classified as “good taxpayers” by SUNAT. Suppliers can ask for a tax refund only after having withholdings in excess of their tax obligations during six consecutive months.
  • Central government spending units (linked to the Financial Management Information System—SIAF) will withhold taxes for government purchases.
  • Large fuel sellers in transactions with fuel retailers would withhold I percent of the sale price.

To intensify control of tax collection, refunds and rebates, specific measures have been defined to:

  • Keep better control of nonexistent taxpayers(taxpayers that cannot be located at their registered address).
  • Introduce expiration dates on purchase invoices authorized by the tax agency.
  • Give the tax agency the right to audit tax years prior to a year in which a taxpayer is in compliance.

The collection of tax debts from government’s suppliers and private companies will be enforced by:

  • Automatically collecting 80 percent of tax debts from central government’s suppliers through the SIAF.
  • Prohibiting firms with tax debts to distribute profits.
Impact of the 2002 Tax Reform(In millions of New Soles)
Second Half

of 2002
2003
TAX POLICY50895
Income tax0645
Introduce new minimum advance payment scheme550
Eliminate allowable deductions under the corporate income tax25
Collect tax on mutual-fund investors’ profits
Increase the maximum marginal income tax rate from 27 to 30 percent150
Introduce an income tax on high pensions under the Cedula Viva (Decree 20530)110
Create a 6 percent income tax on presumed rental income from second homes110
VAT25110
Partial elimination of VAT exemption on fertilizers25100
Restrict the VAT exemption for cultural events10
Fuel excises25140
Increase kerosene excise25140
TAX ADMINISTRATION324665
Withholding mechanisms and tax debt collection259600
Large buyers in transactions of main agricultural products (rice, sugar and alcohol)40120
Large taxpayers in transactions with their suppliers185345
Central government spending units in government purchases740
Large fuel sellers in transactions with fuel retailers1280
From central government’s suppliers through SIAF1515
Other6565
Prohibiting firms with tax debts to distribute profits
Better control of nonexistent taxpayers
Introduce expiration date on purchase invoices
Allow the auditing of tax years prior to a year in which a taxpayer is in Compliance
2002 REFORM3741,560
(In percent of GDP)0.20.8

Measure pending of congressional approval.

Measure pending of congressional approval.

APPENDIX VII Peru: Status of Structural Benchmarks Under the 2002 Program
2002 Structural ReformTarget DateCurrent Status and Comments
Privatization and other asset sales:
Sale of four northern electricity distribution companies (JORBSA)June 30Initially delayed from June 30 to July 16 and then again to August 28. Currently delayed indefinitely.
Privatization of electricity transmission company (ETECEN)June 30Awarded concession on June 5.
Sale of the electricity generation company (EGASA)Sept. 30Completed on June 14, then suspended until court ruling on its validity. Currently the judicial process is ongoing.
Fiscal
Submission to congress of legislation eliminating regional tax exemptionsJune 30Delayed to after November regional elections.
Submission to congress of legislation to include tax expenditures in the 2003 budgetJune 30Sent in August, along with 2003 budget.
Completion of draft legislation of a revision to the Law on Fiscal Transparency and ResponsibilityMarch 31Completed in June.
Submission to congress of a revision to the Law on Fiscal Transparency and ResponsibilityJune 30Sent in November (prior action for completion of the review).
4,300 tax audits completed as of March 31.
SUNAT to carry out 3,400 tax audits of corporations and independent professionalsMarch 31
9,500 tax audits completed as of June 30.
SUNAT to carry out 6,800 tax audits of corporations and independent professionalsJune 30
15,318 tax audits completed as of September 30.
SUNAT to carry out 11,900 tax audits of corporations and independent professionalsSept. 30
Action planned for December 31.
SUNAT to carry out 17,000 tax audits of corporations and independent professionalsDec. 31
Financial system
Submission to congress of legislation to provide the necessary statutory protection to SBS staff in the discharge of their responsibilitiesSept. 30Sent in November (prior action for completion of the review).
APPENDIX VIII Peru: Decentralization Framework
National GovernmentRegional GovernmentsMunicipal Governments
Exclusive Expenditure ResponsibilitiesDefense. National security. Foreign relations. Justice. Money and banking. Public borrowing. Regulation of public services and public infrastructure.Approval of regional development plan (agreement with municipalities). Regional infrastructure (roads, energy, communications). Regional tourism. Approval of changes in territorial limits within the region. Modernization of small and medium enterprises.Urban and rural municipal development. Management of local public services. Local public infrastructure.
Shared Expenditure ResponsibilitiesTo be defined by the Organic Law of the Executive Branch (forthcoming).Education (management of basic, primary, secondary and technical education). Public health. Economic activities (agriculture, industry, etc.). Culture.Education. Public health. Culture, tourism and sports. Civil security, Monument restoration. Public transport. Housing. Management of social programs.
Revenue SourceDiscretionary transfers from the national budget. Regional taxes approved by congress with the initiative of the executive branch. Resources from the regional compensation fund, FONCOR, (which includes: 25 percent of national privatization receipts; and 50 percent of regional infrastructure concessions). Resources from special revenue-sharing agreements in electricity generation, mining, oil, gas, and fisheries. External borrowing operations approved by the MEF.Municipal taxes (real estate, vehicles, cultural events). New municipal taxes approved by congress with the initiative of the executive branch. Fees and lines approved by the municipal council. Resources from the municipal compensation fund, FONCOMUN, (which includes: 2 percentage points of the VAT); 8 percent tax on gasoline sales; resources from special revenue-sharing agreements in electricity generation, mining, oil, gas, and fisheries. External borrowing operations approved by the MEF.
Distribution and Use of ResourcesTo be defined by the Organic Law of the Executive Branch (forthcoming).FONCOR is distributed by the MEF on the basis of poverty, population, fiscal effort, and investment performance indicators.FONCOMUN is distributed by the MEF on the basis of poverty, population, urban development, violence, and natural resources. Resources of FONCOMUN are to be used as defined by the municipal council.
Source: Omnibus Decentralization Law, July 2002.
Source: Omnibus Decentralization Law, July 2002.
APPENDIX IX Peru: Update on FSAP Main Recommendations
Reform MeasuresSpecific ActionsCurrent Status and Comments
Strengthen the autonomy of the Superintendency of Banks (SBS).Provide legal protection for the SBS staff.Legislation sent to congress in November 2002.
Establish an independent SBS budget mechanism.SBS budget not included in annual budget law sent to congress.
Eliminate the coincidence of the term of the appointment of the Superintendent with the political cycle (Constitutional reform).No action taken to date.
Improve the corrective action and bank exit framework.Strengthen the Financial Instability regime by:

- creating explicit time frames for any capital contribution that the SBS may deem necessary.

- making application of the Special Surveillance regime mandatory if the measures required under the Financial are not met.

- conferring explicit powers on the SBS for taking actions in instances of chronic liquidity problems.
No action taken to date. The authorities claim that current regulations to require corrective actions are more than adequate.
Make explicit in the law the application of least cost considerations in any injections of funds from the Deposit Insurance Fund (FSD),The authorities claim that an SBS norm includes this provision.

They have not discussed its explicit inclusion in the banking law
Improve the financial system’s regulatory framework.Reduce the limits on single credit exposure by lowering the legal limit on leasing operations.The SBS submitted to congress a proposal to modify the banking law.
Reduce the limits cm lending to connected parties.A phase-out period of adaptation to lower limit has been established.
Improve the definition and measurement of capital:

- requiring capital on a consolidated basis.

- deducting goodwill from regulatory capital.


Effective since end-December 2001.

Proposed change to banking law sent to congress by SBS.
Improve regulations on money laundering.A law was passed in April 2002 establishing an anti-money laundering unit, and further operational norms are being formulated.
Streamline corporate debt restructuring process.- Simplify procedures.

- Strengthen debtor disclosure requirements.

- Limit the precedence of labor claims of managers and shareholders on companies under restructuring as well as the withdrawal of shareholders from the restructuring process.
A new bankruptcy procedure law effective since October 2002 has dealt with these specific issues.
Sources: Peru - Financial System Stability Assessment, February/2001; and SBS.
Sources: Peru - Financial System Stability Assessment, February/2001; and SBS.
APPENDIX X Tax Exemptions and Benefits, 2003 1/
(In millions of Soles)
SectorTypeDescription of the ExemptionAnnual CostPercent GDP
AgricultureVAT exemptionCertain fertilizers.146.50.07
VAT exemptionFor agricultural goods included in Appendix I of the VAT law.1,437.40.68
VAT exemptionFor agricultural producers whose sales do not exceed 50 UIT.62.60.03
Income tax exemptionFor agricultural producers whose sales do not exceed 50 UIT.17.60.01
Income tax benefitAgricultural sector: rate 15 percent.20.20.01
Income tax benefitAgricultural sector: up to 20 percent of depreciation for hydraulic infrastructure and irrigation can be deferred.33.80.02
Amazon regionVAT exemptionIn jungle regions of Loreto, San Martin, Ucayali, Madre de Dios, and Amazon (except construction).412.80.19
VAT exemptionConstruction and activities inside the Amazon but outside the ancient jungle region.225.50.11
SCT and VAT exemption 2/For fuel sales in the Amazon.169.60.08
VAT benefitTax refund mechanism.82.90.04
VAT benefitSpecial fiscal credit mechanism.15.10.01
Income tax benefitAmazon-5 percent and 10 percent rate.19.90.01
Income tax benefitAmazon-deduction for third party investors.0.00.00
EducationVAT exemptionFor educational, cultural and sports organizations.243.20.00
Income tax benefitCredit for donations.2.80.00
EnergySCT and VAT exemptionFor electricity-generation companies and for the consumption of diesel.23.60.01
FinancialVAT exemptionServices rendered by Private Pension Fund Administration companies.63.30.03
VAT and Income tax exemptionFor financial institutions.250.00.12
VAT and Income tax exemptionFor life insurance contracts.105.50.05
ManufacturingGeneral tax benefit3 percent tax credit for intermediary sales of capital goods.3.00.00
CETICOSSCT and VAT benefit0 percent rate in the ISC for using CETICOS to repare and renovate used vehicles.228.60.11
MiningVAT and trade tax exemptionFor importing input goods for the exploration of hydrocarbon.4.50.00
Income tax benefitAccelerated depreciation.44.40.02
TourismIncome tax benefitAccelerated depreciation.6.60.00
OtherVAT benefitAnticipated tax rebates.198.40.09
income tax benefitRefund for donations from overseas-technical international cooperation.40.00.02
Income tax exemptionFor interest on deposits.184.90.09
Total4,047.51.91
Source: SUNAT.

The fiscal cost recorded in this table is in agreement with the notion of tax expense.

SCT stands for Selected Consumption Tax.

Source: SUNAT.

The fiscal cost recorded in this table is in agreement with the notion of tax expense.

SCT stands for Selected Consumption Tax.

1The staff team comprised Messrs. Wolfe (Head), Rodriguez and Villafuerte (all WHD), Ms. Albino (FAD), and Mr. Keller (PDR). Mr. Velloso (resident representative) assisted the mission. Mr. Pereyra, Advisor to the Executive Director, took part in the policy discussions.
2Of the 25 regional contests, former President Alan Garcia’s (center-left) APRA party won twelve and non-traditional parties (mainly independent regional movements) won ten. These two groups took the majority of the local elections as well. The (center-right) Unidad Nacional gained the important post of mayor of Lima (where one third of the population lives). President Toledo’s Peru Posible won one region.
3Preliminary data suggest that the end-September 2002 fiscal performance criterion on the combined public sector deficit was observed (Table 4 and Box 1).
4Relations with the World Bank and the Inter-American Development Bank (IDB) are summarized in Appendices IV and V, respectively.
5Steps taken regarding tax audits, the FRL, and fiscal transparency were structural benchmarks under the program (Appendix VII). Structural conditionality in Fund-supported programs with Peru is described in EBS/02/12.
6In mid-2002, following the announced sale of two power plants, violent protests led to the suspension of the sale (the legality of the sale is being reviewed by the constitutional court).
7The program had three structural benchmarks on privatization; one was met.
8In 2001, the national government carried out 89 percent of expenditures and collected 87 percent of revenues of the general government.
9Implementing legislation is expected to be approved before year-end (Appendix VIII).
10This is the lowest target range compared with other countries in the region that have adopted an inflation-targeting framework (Brazil, Chile, Colombia, and Mexico).
11MAE has made specific recommendations to further improve the inflation forecast and the way it feeds into monetary policy decisions.
12The Peruvian Sol and the Brazilian Real showed a strong correlation during August-September of this year, but this relationship started to weaken in October (see Figure 4).
13The main Peruvian export products added to the list of eligible products are certain apparel and garment items, footwear, and prepared tuna.
14Growth would be led by exports, both traditional (particularly from new mining projects) and non-traditional (many of which are labor-intensive). Non-traditional exports should benefit from the envisaged hemispheric free-trade arrangement. Growth would also be bolstered by the development of a domestic natural gas industry starting in 2004 when a large project (Camisea) is to begin operations.
15Official reserves would cover over 180 percent of short-term external debt for most of the projection period and would decline only slightly relative to imports and broad money (to 6½ months and 40 percent, respectively) by 2012.
16External debt-to-GDP would fall from 51 percent in 2002 to 31 percent in 2012, with debt service-to-exports declining from 39 percent to 32 percent.
17To ensure achievement of the revenue target, the authorities plan to extend the special wage tax (IES) through end-2003 and would only eliminate it once it is clear that the tax reform is generating the expected revenues.
18On November 25, 2002, the authorities placed US$500 million of global bonds maturing in January 2008, with a coupon rate of 9.125 percent and an effective yield of 9.35 percent (with a spread of 612 basis points over comparable U.S. Treasuries).
19The authorities stated that, even under this scenario, they would continue to treat the SBA as precautionary.
20Such as abandoning the auction schedule, cutting the auctions below the auction target, and allowing government agencies to participate in the auctions.
21The LOI is shown in Attachment I.
22About half of those receipts would come from previous privatizations, and the other half from operating concessions in the energy sector.
23The authorities intend to seek technical assistance from the Fund in the area of regulation of private pension funds.
24As noted in Box 2, banks typically hedge their open forward positions through spot purchases of foreign exchange.
25In 2002, tariffs on certain capital and intermediate goods were lowered from 12 to 4 and 7 percent.
26Those underemployed work less than 35 hours a week or (working more than 35 hours) earn less than half the cost of the standard family consumption basket. At end-2001, the rates of underemployment and unemployment were 47.6 and 7.9 percent, respectively.
27Previously, the Service Time Compensation Scheme (CTS) provided a form of unemployment insurance. Firms paid one half a salary every six months into an interest-earning account for workers (from which up to 50 percent could be withdrawn at any time).
1Tax administration measures are expected to yield 0.2 percent of GDP in 2002 and 0.3 percent of GDP in 2003, respectively. By law, changes in income taxes take effect in the following calendar year.
2This measure has not yet been approved by Congress.
3The approval of congress to extend this withholding mechanism to fishing is still pending.

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